26/9/22, 10:59 Breaking the sovereign debt impasse | Financial Times

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Breaking the sovereign debt impasse
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Debt restructuring is logjammed by inter-creditor bickering © Ron Sanderson/Creative Commons

Lee Buchheit and Mitu Gulati 5 HOURS AGO

Lee Buchheit and Mitu Gulati are currently teaching a class on international law
and sovereign debt at the University of Virginia Law School.

Things have changed since the days when debt-stricken countries only had to
negotiate with government creditors in the so-called Paris Club and with the
commercial lenders that typically formed ad hoc negotiating committees.

Each group was suspicious that the other might get better debt restructuring
terms. The Paris Club attempted to neutralise this risk by requiring sovereign
debtors to commit to “seek” from other lenders — both commercial and non-Paris
Club bilateral creditors — restructuring terms no less favourable to the debtor than
those agreed with the Paris Club. This embodied what the Paris Club called its
“comparable treatment” principle.

Over the past decade, however, China (very much not a member of the Paris Club)
has become the world’s largest bilateral creditor. A sovereign borrower today must
therefore negotiate not only with its Paris Club and commercial creditors, but also
with other bilateral lenders such as China, India and South Africa.

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China’s predilection for ad hoc and bespoke restructurings, combined with an

almost obsessive concern with confidentiality, has only stoked inter-creditor
mistrust and this has led to stalemates in recent restructurings by countries such
as Suriname and Zambia. None of the three creditor groups — Paris Club,
commercial, and non-Paris Club bilateral — wants to agree to a restructuring deal
until they know for certain that the others will accept comparable terms. And if a
creditor such as China is reluctant to negotiate, or is bashful about disclosing the
terms of its debt relief, the entire process grinds to a halt.

The G-20 intended to fix this problem in November 2020 for 73 of the world’s
poorest countries with its “Common Framework” for debt restructurings. Under
the Common Framework, China and other non-Paris Club bilateral lenders sit at a
single negotiating table with the traditional Paris Club creditors and, once a deal is
struck, the sovereign debtor is expected to obtain comparable debt relief from its
commercial creditors. Nearly two years after the Framework was unveiled, only
three countries have signed up for debt treatment under its terms. Not one has yet
closed a debt restructuring. The Common Framework thus didn’t cure the arthritis;
it fell victim to it.

Breaking the impasse

A stalemated sovereign debt restructuring, while irksome for creditors that are not
being paid, can be disastrous for the sovereign borrower. The IMF has gradually
fashioned internal rules to ensure that a recalcitrant creditor — commercial or
bilateral — cannot block the Fund’s approval of a program for the debtor country.
Until a country’s legacy debt burden is lifted, however, the country cannot expect
the new investments and capital-market access that would enable its economy to
recover. Years, sometimes decades, can pass with the country’s economic pulse
barely discernible under a thick blanket of old debts.

Can a sovereign debtor do anything to accelerate the resolution of its unsustainable

legacy debts? What is needed is a credible way of assuring each creditor group that
once a restructuring agreement is reached with them, no other creditor group can
later extract from the debtor more favourable (to the creditor) treatment. Any
solution requiring prior consent from each of the competing creditor groups,
however, could fall prey to the same paralysis that has afflicted recent debt
workouts Thus whatever form the remedial measure takes the sovereign
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workouts. Thus, whatever form the remedial measure takes, the sovereign
borrower must be able to implement it unilaterally.

Most Favoured Creditor clauses

One option might be an enhanced Most Favoured Creditor (or MFC) clause. MFC
provisions have sometimes been included in sovereign debt restructuring
agreements with commercial lenders to dissuade prospective holdouts.

These clauses contain a promise by the sovereign debtor that if ever it pays or
settles with a holdout creditor on better terms (for the creditor) than those agreed
with the majority of its commercial lenders, the debtor will reopen the majority
deal to give the same sweeter terms to everyone else. Because such a reopening
would be extraordinarily unlikely to happen, prospective holdouts are expected to
deduce that their chances of extracting preferential terms are slim to none.

MFC clauses do not forbid the debtor from granting more favourable terms to
other creditors. Lawyers have warned that an outright prohibition of this kind
might expose the majority lenders to a claim that they had wrongfully interfered
with the sovereign’s other contractual relationships. Further, an outright
prohibition — to the extent that it could be characterised as lowering the legal
ranking of the holdouts’ claims — might invite pari passu injunctions similar to
those Argentina faced in 2011.

An MFC clause seeks to achieve the same result as an outright prohibition by

making it practically and politically impossible for a country to bestow a holdout
creditor’s richer terms upon all of its other commercial lenders.

An example is the MFC clause described in the term sheet for Poland’s 1994 Brady
exchange:

Provision will be included to ensure that in the event that any Obligor
enters into, agrees to enter into, or offers to enter into any voluntary
arrangement or compromise of any nature relating to Eligible Debt
with any Creditor under any Debt Agreement other than pursuant to
these Financing Proposals (an “Alternative Proposal”), Poland will, or
will procure that the relevant Obligor will, extend such offer to make
available to each Creditor whose Eligible Debt is exchanged or bought
back on the Exchange Date, the Alternative Proposal in relation to such
Eli ibl D bt
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Eligible Debt . ..

The MFC clauses in sovereign debt restructuring agreements with commercial

lenders are intended to assure equal treatment within the universe of commercial
creditors. The only example of a MFC provision designed to operate across
different creditor groups is the Paris Club’s comparable treatment clause.

The Paris Club provision, however, only requires the sovereign borrower “to seek”
comparable concessions from its other lenders. The Club has never confided what
would happen if a debtor seeks but does not find such an accommodation, nor
have any historical Paris Club settlements answered this question. In contrast,
MFC clauses expressly disclose the consequence if a sovereign grants better terms
to a holdout commercial lender: those terms must be offered to all creditors who
signed the original restructuring agreement.

The most notorious MFC clause was the “Rights Upon Future Offerings” provision
(RUFO) included by Argentina in its 2005 debt restructuring. This clause said that
if Argentina, for ten years following the 2005 restructuring, made a voluntary offer
to purchase, exchange or amend bonds that had not been tendered in the main
debt restructuring on terms better than those contained in the main restructuring,
Argentina would need to make that same offer to the bondholders that had
accepted the original deal.

Commentators at the time questioned whether a court-ordered repayment of a

holdout creditor’s claim would really be “voluntary” and thus trigger the RUFO.
Before its RUFO clause expired at the end of 2014, Argentina repeatedly argued in
court that the clause prevented the country from settling with holdout creditors.
When December 31, 2014 came and went, however, Argentina remained unwilling
to settle with its holdouts.

Breaking logjams with MFCs

That brings us back to the main problem: in recent sovereign debt workouts
involving the three major creditor groups (commercial, Paris Club and non-Paris
Club lenders such as China), each group has been reluctant to proceed with needed
restructurings without assurances that the other groups will provide comparable
debt relief.

Bondholders, for example, do not want to see the cash liberated by their
i b i d bil l di i i l Chi
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concessions being used to pay bilateral creditors on original terms. China does not
want its debt relief to subsidise hedge fund managers in Mayfair or Greenwich,
Connecticut. Paris Club creditors such as the US do not wish to relinquish or
stretch out their claims only to see those funds diverted to pay back loans from
China’s Belt and Road Initiative.

The result? If any creditor group procrastinates in the debt restructuring process,
or baulks at disclosing its settlement terms, the entire operation stalls, often at a
painful cost to the sovereign debtor and other lenders.

The MFC clauses in sovereign debt instruments held by commercial creditors have
never been very specific about the exact process that would be followed if the
provision is violated. There is a good reason for this: the clause is never supposed
to be triggered. The MFC is a contractual doomsday device.

The consequences for the sovereign debtor of triggering the clause (reopening the
restructuring agreements with all other commercial lenders and improving their
financial terms) are so unpalatable, the theory goes, that the sovereign would
rather litigate for years or decades with holdouts than face those consequences.
Recognising this, contract drafters have never felt it worthwhile to describe the
mechanics for how such a theoretical reopening might be accomplished.

A cross-creditor group MFC, however, may not be able to rely exclusively on the
clause’s in terrorem value to ensure co-operation from all parties. An enhanced
MFC contractual provision would promise that if a debtor restructures claims of (i)
a supermajority of commercial lenders, (ii) Paris Club creditors (who can be
expected to act jointly) or (iii) any of its non-Paris Club bilateral creditors, and
later agrees to give better terms to one or both of the other creditor groups, those
richer terms will be offered to all.

An enhanced MFC designed for this purpose might contain the following features:

Transparency. The sovereign debtor will need to disclose to the other creditor
groups the terms of all of its debt settlements with holders of claims that are
subject to restructuring, notwithstanding any prior contractual promises to keep
those terms confidential.

Uniform methodology. Because the format of debt settlements may differ

(reductions in principal, maturity extensions, interest rate adjustments, etc), a
uniform methodology will be needed to assess the net present value of each
settlement, using a common discount rate. An independent calculation agent
should make these assessments.

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Enforcement. MFC clauses can be particularly effective if they threaten legal

consequences for any lender that suborns a breach by the sovereign debtor of its
MFC obligations. In legal terms, the new lender worries that it may be accused by
other creditors of having tortiously (wrongfully) interfered with their contractual
relations with the borrower. Of equal, possibly greater, utility would be a threat
that any creditor group colluding with the sovereign debtor to violate the MFC
undertaking could face judicial injunctions similar to those that prevented
financial intermediaries from processing payments on Argentine bonds during the
pari passu dust-up between 2011 and 2016.

Flexibility. Lenders may want to include some mechanism allowing a

supermajority of the creditors benefiting from the MFC clause to waive its
application in exceptional cases. For example, if a non-Paris Club bilateral creditor
offered a debtor country new concessional loans in return for a milder
restructuring of its existing exposure, the country’s other lenders might conclude
that this was in their collective best interest.

Considerations

Using a cross-creditor group MFC clause to reduce competition (and suspicion)

among creditors is a serious step for a sovereign debtor.

In practice, if a creditor group such as the supermajority of commercial lenders or

a non-Paris Club bilateral creditor like China refuses to accept comparable debt
relief, the borrower would be obliged to run arrears to that uncooperative creditor,
perhaps indefinitely, or else reopen the terms of previously concluded debt
restructurings. This could have diplomatic, financial, perhaps even legal
consequences.

The IMF also has elaborate rules regarding what the Fund calls “lending into
arrears.” Those policies generally say that the Fund can keep lending to a member
country that has not yet finished restructuring unsustainable debt, as long as the
country is negotiating in good faith with the relevant creditors.

It would need to be clear that any sovereign debtor that is contractually bound by a
MFC provision would be “negotiating in good faith” as long as it continues to offer
comparable terms to all lenders.
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