"OFFICIAL" BONDHOLDER: A NEW HOLDOUT CREATURE IN SOVEREIGN DEBT RESTRUCTURING AFTER VULTURE FUNDS?

• Published date: 22 September 2017
• Author: Yu, Hancen
• Date: 22 September 2017

For years, holdout litigations have posed a threat to the successful restructuring of sovereign bonds. Among these holdout creditors, the vulture funds have been particularly deft in manipulating the system. To prevent holdout litigation, sovereign debtors and creditors use various contractual devices--some of which have proven to be successful. During the recent Ukraine-Russia sovereign bond dispute, a new type of holdout creditor immerged--one that is potentially immune from these contractual arrangements. This note will begin by presenting an overview of the process of sovereign debt restructuring. It will then explore the problem of holdout litigation in bond restructuring and the solutions currently available. Finally, the dispute between Ukraine and Russia will be examined as it has brought a new dimension to this already complicated problem.

I. INTRODUCTION TO SOVEREIGN DEBT RESTRUCTURING

Typically, when a creditor and debtor sign a loan agreement, the creditor delivers the proceeds to the debtor and is repaid the debt over a number of subsequent months or years. (1) A default takes place when the debtor fails to meet its obligations under the agreement. (2) Such default usually triggers an acceleration clause in the debt agreement; this clause allows a creditor to accelerate the entire debt and collect any amounts outstanding. (3) Sovereign debt is the debt issued or guaranteed by the government of a sovereign state. (4) When a debtor country defaults on the debt, (5) it will seek a "restructuring" of the debt. This restructuring is conducted though a legal process and involves "an exchange of outstanding debt instruments... for new debt instruments or cash." (6)

A sovereign debtor is different from a private debtor for several reasons. Most notably, the possibility of liquidation (7) is "out of consideration" for a national sovereign. (8) The sovereign debtors are also regarded as "too big to fail," (9) since a default on sovereign debt could trigger an economic domino effect--such as a currency collapse, bank runs, trade disruptions, and macroeconomic contraction. (10) Concerns over these spillovers have facilitated a belief that sovereign countries must be bailed out by public funds. (11) This expectation of official bailout in turn causes a moral hazard as it creates an incentive for the sovereign debtors to adopt a less prudent economic course. (12)

While the value of domestic debt is inherently built upon the "framework of laws and institutions that support them," (13) creditors of sovereign debt enjoy less protection as their enforcement mechanisms are limited. (14) First, as a practical matter, few sovereign assets are located in foreign jurisdictions creditors are able to reach. (15) Second, sovereign debtors have various special formal defenses available to them to avoid repayment. The sovereign could assert sovereign immunity from suit and execution. (16) It could also resort to the principle of international comity, which recognizes that one country may, "out of international duty and convenience," voluntarily enforce the laws of another country. (17) Another legal defense is the act of state doctrine. (18) Unlike the comity defense which limits the court's jurisdiction, the act of state doctrine allows the court to determine whether judicial interference runs the risk of embarrassing the executive branch. (19)

Finally, a special defense may arise when the debtor state inherits a debt incurred by the predecessor government. In that case, the debtor could use the "odious debt" argument to repudiate the agreement. (20) Two types of odious debt have been recognized by the international community: war debts and hostile debts. (21) A third type of odious debt--which emerged in the early twentieth century--is broader. (22) This type of debt is called "regime debt" (23) and is incurred by a lender for illegitimate purposes and often treated as a personal loan. (24) This debt is usually only repaid out of state funds if the ruler remains in power. (25) An example of regime debt is the debt incurred during President Tinoco's reign of Costa Rica. (26) The doctrine is also used in World Duty Free v. Kenya, a famous arbitration that occurred in 2006. (27) In that case, the tribunal ruled the contractual obligation was incurred because of a bribe and was void for international public policy reasons. (28) Though the defenses of war debt and hostile debt have been generally accepted, the regime debt argument remains controversial. (29)

A. The International Regime for Sovereign Debt Restructuring

A typical restructuring process starts with the sovereign debtor initiating a "negotiation or preparation phase." (30) The debtor country, assisted by the staff of the International Monetary Fund (hereinafter "IMF"), will verify the total debt claims; this includes all loans, bonds and other debt instruments. They will then conduct a "detailed debt sustainability analysis." (31) The goal of the country is to secure an "economic reform and interim financing program" from the IMF. (32)

The interim financing program, however, is only temporary. The debtor will then negotiate with its creditors for a long-term restructuring plan. (33) Among the various creditors, the debts owed to international financial institutions--such as the IMF, World Bank, and other multilateral development banks--are respected by the debtor. (34) Their de facto priority is generally accepted because the sovereign desires to "maintain its future access to emergency financing and a good working relationship with other governments"; for the IMF in particular, financing to the debtor country is tied to the country's policy changes. (35)

The debts owed to the national governments or bilateral lending agencies will be restructured under the Paris Club framework. (36) The Paris Club is an "informal group of creditors and ad hoc negotiation forum, consisting of the governments of "nineteen of the largest world economies plus additional creditor governments on a case by case basis." (37) The government creditors will agree to grant relief according to their preset reduction formulas and obtain the debtor's "commitment to get 'comparability of treatment' from other public and private creditors." (38) Commercial banks loans are restructured via the London Club--a "term that loosely describes the case-by-case restructuring routine developed between Western banks and developing countries in the late 1970s." (39) In the London Club process, the debtor country will negotiate with the Bank Advisory Committee acting as the representatives of the creditor banks. (40) This process is preferred because commercial banks usually use a "syndicated loan" (41) to spread risk among themselves. (42)

The last category of sovereign debt creditors is private creditors other than commercial banks, which typically consists of bondholders. (43) There is "a general impression that bonds are senior to bank loans"; one reason is that the investors expect the borrowing country to restructure its bank loans first before it seeks recourse in bond restructuring. (44) Sovereign bonds are in general restructured with "exchange offers." (45) After it negotiates with each of these categories of creditors, the debtor country will present the restructuring offer to all creditors. (46) A successful exchange usually requires a "certain minimum threshold of acceptance by creditors" within each category. (47) Once the offer is accepted, the restructuring is completed. (48)

B. Sovereign Bonds: The Hotbed of Sovereign Debt Disputes

i. The Rise of Tradable Bonds in Credit Markets

In the 1980s, most of the sovereign debts were syndicated bank loans. (49) The London Club process was "heavily used" during this period when countries in the developing region defaulted on their debt. (50) Intracreditor disputes were a major problem for bank debt, causing delays in implementing the deal. (51) In contrast with bank loans, sovereign bonds were in small scale and considerable defaults did not take place. (52) These bonds "escaped restructuring during the workouts" in the 1980s. (53)

A major policy change occurred in the late 1980s when the U.S. Treasury announced the Brady Plan, which allowed the countries in default to convert their bank loans into sovereign bonds. (54) Such "exchange of commercial bank loans for tradable bonds" created a "sustainable secondary market for developing country bonds at the beginning of the 1990s." (55) While banks became more "cautious about lending to the governments" after the bank crisis in 1980s and the write-offs associated with the debt exchange in 1990s, bond financing became the "dominant form of private lending." (56) As a result, the emerging markets witnessed "a new wave of capital inflows" (57)

The shift from bank loans to tradable bonds in the lending market has caused the atomization of the creditor community and the dispersed debt situation. (58) The sovereign bonds are owned by bondholders with widely differing institutional characteristics. (59) Moreover, creditors can purchase sovereign bonds in the market at different prices. (60) Those who pay a price close to the face value of the bonds prefer restructuring plans which preserves the face value of the bonds, while those who purchase at a steep discount are more willing to accept a facial reduction. (61) As a result, coordination among bondholders becomes an issue in sovereign bond restructuring. (62)

ii. Holdout Litigation and Vulture Funds

Like bank loans, sovereign bonds can be restructured through a voluntary exchange offer. (63) This means the dissenting bondholders could opt out and sue the sovereign debtor in courts to obtain full payments. (64) These holdout litigations pose a classic case of free riding, impairing the economic welfare of all creditors by discouraging participation, and delaying the reaching of an agreement. (65) The practice of holdout litigation has increased significantly...