Lee Buchheit and Mitu Gulati are currently teaching a class on international law and sovereign debt at the University of Virginia Law School. A longer version of this piece is now up on SSRN.
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.
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 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 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 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.
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.
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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