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Sovereign debt after March 2013

By Muti Gulati


It is perhaps natural human tendency to think that the big events that occur during our lifetimes — particularly if they involve us personally — are both unique and will change the course of history. Reality though is that most of us aren’t particularly good at predicting what future historians will consider important. Worse, we tend to dramatically exaggerate the importance of events that we have watched occur. Rogoff and Reinhart’s bestselling treatment of the history of sovereign debt has the ironic title This Time is Different precisely because of how often we are wrong in thinking that “this time is different.” Having provided these cautions, I am going to fall into the precise trap I warned against and assert that the period between March 2012 and March 2013 will go down in history as one of the most eventful ever in the history of sovereign debt. This time is different. Why?

There are a number of candidates in terms of potentially game changing events that occurred in the sovereign markets over these past twelve months. As a backdrop to these events, we are in the midst of what is likely one of the most biggest sovereign debt crises in history: the crisis of the euro area.  That crisis, which began with European politicians swearing up and down in 2010 and 2011 that no Eurozone country would ever default, saw Greece, in March 2012 impose one of the biggest and most severe haircuts on private sector creditors in history. Euro area politicians who (like me) seem to have little concern for how historians might subject their statements to ridicule in hindsight are now announcing loudly that the Greek restructuring was “unique and exceptional”.

So much happened within the Greek restructuring that was new, and even when not new, certainly eventful.  Foremost, there were the legislatively mandated Collective Action Clauses that were imposed on local law governed debt instruments. Then was the drama over whether the Greek restructuring was voluntary or not and whether the CDS contracts would be triggered (hard to imagine how anyone could think that a creditor taking a 70% haircut was doing so voluntarily; but that argument was made at various points). And if that was not enough, at the nth hour in the Greek restructuring, the European Central Bank demanded for itself, as a legal right, super priority over all other creditors — essentially the right to be exempt from the restructuring. As a matter of optimal rules for the system, there is probably an argument for Official Sector lending by institutions like the ECB and the IMF to be given super priority. But the ECB’s priority claim, unlike IMF claims in the past, was with respect to bonds that it had purchased on the market just as if it were an ordinary investor. There was a risk, therefore, that investors who had entered the Greek exchange would bring a legal claim against the ECB for having received an illegal priority. As of this writing it is not clear whether any of the claims that have been threatened will bear fruition, but the can of worms regarding the precise contours of Official Sector priority has been opened.

There was more that didn’t make the daily headlines, but will probably make the history books. There was the explicit inclusion of some of Greece’s sovereign guarantees in the restructuring (no one quite understands why some guarantees got ensnared and others escaped completely, but that is a matter for a different day). And then there were was the treatment of the foreign-law bonds in the Greek deal. There was some attempt to extract a haircut from them; but the attempt was half-hearted at best — much more could have been done to turn the screws. Which, in turn, raises the puzzle of why the holders of those foreign-law bonds (many of whom likely go under the moniker “hedge fund”) were treated with such solicitude Literally, the holders of some of these foreign-law bonds were just asked politely whether they would like to restructure and when they said no (some did say yes), they were paid in full and on time. By contrast, the holders of the local-law bonds got taken to the woodshed.

The events in Greece itself would have entitled the past twelve months to go down as one of the most eventful in periods in sovereign debt history. But so much more happened as well. In Ireland, to restructure the debts of one of the banking institutions at the center of that nation’s crisis, the authorities invoked a technique called the Exit Exchange. This technique, through the 1990s, had been used to successfully engineer multiple sovereign debt restructurings (among them, Ecuador, Uruguay and the Dominican Republic). The technique is one that is aimed at, to put it politely, incentivizing holdout creditors to accept a restructuring offer that a majority of other creditors like, but that the holdouts would rather not take. As a legal matter, utilizing the technique has always been a tricky matter, since there is a fine line between deterring holdout creditors from blocking a deal that is in the collective interest of the creditor group and coercing the whole group. In the transactions, the Irish authorities decided to go on an all out attack in terms of the “offer you don’t want to refuse” that they presented creditors with. The debt in question though was governed by English law and an English judge in Assénagon Asset Management v. IBRC decided that the aforementioned line had not only been crossed, but abused and trampled. So much so that he wrote an opinion that called into question the validity of all future uses of the technique. Whether the opinion is followed by other courts is yet to be seen. But I suspect that regardless of how much commentators complain about the Assénagon case, the Exit Exchange technique will never be the same.

In the meantime, while announcing that the Greek restructuring was “unique and exceptional”, the euro area authorities mandated, starting January 1, 2013, what is easily the biggest change in contract language in sovereign debt contracts ever. All Eurozone sovereign debt contracts, regardless of governing law or other provisions, will henceforth (with minor allowances for a transition period) will contain Collective Action Clauses or CACs. These E-CACs in question are the technical devices that Greece imposed on its bonds legislatively so as to be able to engineer its March 2012 restructuring. The Eurozone has put into effect in all bonds for all of its members, much the same mechanism that Greece utilized. There are at least two things about this Euro CAC initiative that are historically significant. First, the reform attempts to change the standard template for not just foreign-law governed bonds (the focus of prior contract reform attempts), but also local-law bonds. Second, the contract terms here are being mandated. Prior to this, sovereigns had always chosen the contract terms that they thought best suited their individual interests.  No longer; at least not in the euro area. The policy decision was made that one size should fit all. It might be a bit puzzling to some of us as to why, given the supposedly “unique and exceptional” character of the Greek restructuring these E-CACs are needed, but only time will tell.

To repeat myself, the foregoing should have been enough to conclude that the past twelve months were the most significant twelve month period in the history of the sovereign debt markets. But we have not gotten to the biggest event of them all — the holdout litigation against Argentina in the Second Circuit Court of Appeals in New York.

The defining feature of sovereign debt, for time immemorial, has been that such debt is near impossible to enforce. Sovereigns, pretty much, have always been able to thumb their nose at creditors whenever they wanted. They pay because they want to, not because they have to. On rare occasions, there have been creditors who were important or big enough that they could get their nation’s gunboats to act as enforcers, but these events have been few and far between. And, in any event, using gunboats to enforce debt isn’t really allowed these days. Indeed, in the academic literature, there is a cottage industry of articles asking the question of why, absent enforcement, anyone in the modern era lends to a sovereign.  Well, all of that may have changed. The seeds of this change were laid in an obscure case in Brussels from a decade ago. The case provided a radical interpretation of a standard provision in sovereign debt contracts that everyone used (the pari passu clause), but almost no one understood. For about a decade or so, the implications of that case were largely dismissed by the pooh bahs of the sovereign market. No one else would follow this outrageous Belgian decision, they said. That is, until October 26, 2012, when the theory from that Brussels litigation found favor with a three-judge panel of the Second Circuit in New York — arguably the most sophisticated court on business matters anywhere. That case, that has been occupying the pages of the financial papers for some time now, and is the centerpiece of the most recent issue of the Capital Markets Law Journal, is NML Capital v. Republic of Argentina.

To reiterate, the basic enforcement problem with sovereigns is that sovereigns themselves are hard to sue and harder still to enforce against (most of their assets tend to be on their home soil). Enterprising creditors though, figured out that while they might not be able to get at the sovereigns themselves, they could perhaps get at others who the sovereigns cared about, who were less able to protect themselves (any fan of movies about the mafia and its enforcement techniques will immediately grasp the basic idea). Ordinarily, we suspect that a court would not have gone down the path of enabling creditor action of this type. But the defendant in this case is special — it is the Republic of Argentina, that (some might say) has been doing its best to aggravate and annoy the federal courts in New York for over a decade where unpaid creditors have been litigation ever since Argentina’s mammoth default a decade ago. NML Capital v. Republic of Argentina allows the creditors to get at the third parties; in particular, financial intermediaries, but maybe also other creditors who the Republic is choosing to pay while stiffing the holdouts. If NML v. Argentina holds up on appeal — and, as of this writing, it has held up well — this will mark the most fundamental change in sovereign debt in multiple centuries. These debts will now be enforceable. It still won’t be easy to enforce, but it won’t be impossible.

To show how this case has already had an impact on the direction of future events, on 4 March 2013, just a few weeks ago, the tiny Caribbean island of Grenada was on the receiving end of a request that third parties be enjoined, just as they were in NML. And this injunction was not sought by some hedge fund in Greenwich, Conecticut. It was requested by the Taiwanese Ex Im Bank. It may not be that long before we see suits against other nations who have long unpaid debts. Rumors of the potential impact of the NML decision seem to have even trickled down to the market for antique bonds. The owner of my favorite antique bond shop tells me that defaulted Chinese and Russian bonds from the early part of the twentieth century have increased in price in recent months; and particularly the ones with pari passu clauses (yes, she said “pari passu”). Somebody out there thinks that the probability of recovery on these bonds has just increased. I do wonder whether their excitement will wane somewhat when they tackle the statute of limitations issue.

And then there is Cyprus. On Friday, 15 March 2013, European leaders trespassed on consecrated ground. They insisted that Cyprus impose losses — euphemistically dubbed a “solidarity levy” — on insured depositors with Cypriot banks as a condition to receiving EU/IMF bailout assistance. Cyprus was in deep crisis thanks to its oversized banking sector. Contrary to anything anyone expected (other than perhaps the nincompoops in the room that Friday night), Cyprus decided not only to go after bank deposits, but also insured deposits. And at the same time, it also decided that it would pay its bonds — a sizeable portion of which were rumored to be held by foreign hedge funds — on time and in full. Faced with almost universal shock and criticism for its first decision, Cyprus quickly backed off its first plan (its legislature did not even give the plan a single vote), and has now put in place an alternate plan that primarily pursue uninsured depositors in some of its weakest banks (for some bizarre reason, the bondholders still get paid in full). It is not clear that the current plan will suffice, given the damage that the announcement of the first plan and the general move toward chasing deposits for debt relief has done to the Cypriot banking sector (the key industry for that small economy). In other words, Cyprus will probably need more debt relief than it had first calculated and the bondholders may yet get whacked. But, for purposes of this note, I’ll say just this: Wow.

This is an updated and expanded version of the Editor’s Note in the current issue of Capital Markets Law Journal.

Mitu Gulati is the North America Regional Editor (March 2013) for Capital Markets Law Journal. He is a Professor at Duke University. His research interests are currently in the evolution of contract language, the history of international financial law and the measurement of judicial behavior.

Capital Markets Law Journal is essential for all serious capital markets practitioners and for academics with an interest in this growing field around the World. It is the first periodical to focus entirely on aspects related to capital markets for lawyers and covers all of the fields within this practice area: Debt; Derivatives; Equity; High Yield Products; Securitisation; and Repackaging. With an international perspective, each issue covers articles and news relevant to the financial centres in the US, Europe and Asia.

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