A small step, but a step nonetheless, towards international sovereign debt reform

Barry Herman cautions that while the UN resolution is a step forward in the fight for an international debt restructuring mechanism, realisation of the goal will still face resistance from member states opposed to it. He suggests how despite this, a positive outcome can be achieved.

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THE United Nations General Assembly adopted a resolution on 9 September aimed at reforming the process for sovereign debt 'workouts', which the international community applies after countries trip (or are tripped) and fall into debt crises. Many commentators see that resolution as path-breaking. Unfortunately, it is only just a delicate opportunity for real reform, but it is an opportunity nevertheless. The resolution had and presumably still has enemies among governments at the UN that can prevent it from leading to actual policy change. However, it may be possible to win those governments to the side of discussing reform or at least expressing neutrality rather than full-blown opposition. This requires a bit of explaining.

General Assembly resolution 68/304

The resolution, titled 'Towards the establishment of a multilateral legal framework for sovereign debt restructuring processes', has two operative paragraphs at its end that embody the new commitment:

'The General Assembly.

'5. Decides to elaborate and adopt through a process of intergovernmental negotiations, as a matter of priority during its sixty-ninth session, a multilateral legal framework for sovereign debt restructuring processes with a view, inter alia, to increasing the efficiency, stability and predictability of the international financial system and achieving sustained, inclusive and equitable economic growth and sustainable development, in accordance with national circumstances and priorities;

'6. Also decides to define the modalities for the intergovernmental negotiations and the adoption of the text of the multilateral legal framework at the main part of its sixty-ninth session, before the end of 2014.'

In other words, the General Assembly agrees to negotiate and adopt a 'legal framework' that could be applied to the processes (note the word is plural in the resolution) that govern - or should govern - how sovereign debt crises are resolved. This work is to be carried out during the Assembly's 69th session, which runs from mid-September 2014 to mid-September 2015. Before the end of 2014, however, the Assembly should define how it intends to carry out this task, i.e., it should 'define the modalities for the intergovernmental negotiations and the adoption of the text'.

By September 2015, according to the resolution, the Assembly should have agreed on a text for a legal framework. The Assembly usually adopts a text by agreeing to it as a resolution. An Assembly resolution is not legally binding but rather a normative statement to which governments give more or less political standing, depending on its content and degree of political support underlying the formal wording of the text.

A more consequential outcome would be to agree to transfer the discussion to a treaty negotiation process wherein the framework would be adopted as the main part of a 'convention', which would also specify how it would come into force. On completion of the negotiations, senior representatives of member states intending to adopt the convention sign it but it then has to be ratified by each of the governments. It only comes into force when the requisite number of countries specified in the convention has completed ratification. Notably, the first draft of what became resolution 68/304 would have had the Assembly 'express its determination to adopt a multilateral convention establishing a legal regulatory framework for sovereign debt restructuring processes'. The resolution that was finally adopted has a more modest goal. The Assembly could return to the idea of formulating a convention, but that appears unlikely for the time being.

Nevertheless, a consensus resolution on a debt crisis resolution framework could be accorded a high political standing, as it would ipso facto represent the shared view of the global community. The member states of the Group of 77 (G77) and China, the developing-country caucus at the UN, have enough votes to adopt any resolution. However, a voted resolution would be understood to reflect only the views of the Group. Resolution 68/304 was a case in point, as it was adopted by a vote of 124 in favour, 11 opposed and 41 abstentions. On the other hand, developed countries did not vote 'no' as a block, as witnessed by the numbers abstaining. In other words, there is a group of countries outside the G77 that might be willing to pursue the initiative after further discussion and it remains to be seen how firm the opposition is among the 'no' votes. Building to a consensus is the central challenge facing proponents of the resolution.

It is also important to note that the resolution does not call for establishment of an international 'mechanism' for sovereign debt workouts. In particular, it does not call for a 'statutory regime' to replace the current largely market-based regime for restructuring debts owed to private creditors, although this is how the representative of the United States (Terri Robl) read the text of the resolution (as per UN Department of Public Information, meetings coverage release, GA/11542, 9 September 2014). The resolution does not call for a court for insolvent sovereigns or an arbitration panel or even a mediation service. It just calls for a legal framework. That would be an intermediate step towards a different way to resolve sovereign debt crises. For that reason, perhaps it is an attainable step.

The resolution does not specify what is meant by a 'legal framework'. It acknowledges that a 'sound' one does not currently exist and is needed to facilitate the 'orderly restructuring of sovereign debts' so as to allow 'the re-establishment of viability and growth'. It should not 'inadvertently increase the risk of non-compliance' of creditors with the terms of a debt restructuring and it should deter 'disruptive litigation that creditors could engage in during negotiations to restructure sovereign debts'.

There is a reflection here of the recent Argentine difficulties with non-compliant bondholders who have pursued disruptive litigation against Argentina. In fact, an approach exists today to reduce the risk of non-compliance by holders of sovereign bonds that was not commonly in use when Argentina issued the bonds that are at the centre of its current conflict with a group of speculative hedge funds. The new approach is embedded in the 'small print' or 'boilerplate' terms of the bond contract. It specifies what majority of bondholders is needed to approve a change in the bond's financial terms. When that majority (typically 75%) agrees, the minority is legally required to accept the proposed change. Moreover, in addition to such 'collective action clauses' (CACs) in individual bond issues, it is now conventional to specify in a bond contract that if a specified majority of all the holders summed over all outstanding different issues of similar bonds approves a change, then the rejecting bondholders are forced to accept the change even if they own a majority of one or more issues and could otherwise reject the change on an individual issue basis. This is called an 'aggregation clause'.

Over time, the specifications of standard CACs and aggregation clauses have been revised to strengthen them so as to more effectively deter speculative efforts to undermine bond restructurings. However, CACs and aggregation clauses are not all that is at stake. Firstly, this approach applies only to bond restructuring and not to arrangements with official and other private creditors besides bondholders, whose repayment schedules may also need to be adjusted. Secondly, it pertains to only one aspect of a bond workout, namely getting the bondholders to agree to a restructuring of their bonds, usually meaning accepting the necessity to take a loss (a 'haircut' in the jargon of Wall Street). Thus, adoption of an internationally agreed legal framework that applies across all types of creditors and that takes into account the imperative to 're-establish viability and growth' would certainly be a global policy advance.

Argentina's leadership

The Argentine government took the initiative to formulate and win adoption of resolution 68/304. Indeed, Argentina's Foreign Minister, Hector Timerman, was present when the Assembly voted to adopt it. It is fair to ask: why this? Why now? One good hypothesis is that it was a response to a series of adverse decisions in US courts that overturned certain accepted legal principles under which the sovereign bonds of Argentina and other countries have been restructured for decades.

To understand this, one needs to note that, even though sovereign governments have special immunities in the courts of foreign countries, they can be sued in those courts in a restricted range of cases. Within that range, private creditors of a foreign government can sue for repayment on the grounds that the terms of a loan contract had been violated. As many of Argentina's bonds on which it had to default at the end of 2001 had been issued under New York law, bondholders could sue Argentina in the US courts.

In fact, most bondholders do not sue as it is costly in terms of legal expenses and uncertain outcomes. They accept that the insolvent government will seek to 'cure' its default as it is a prerequisite to returning to the market to borrow again, which it ultimately will want to do, if for no other reason than to roll over maturing debt instead of just paying it off. The bondholders also appreciate that, by definition, an insolvent government cannot honour all its payment obligations. As with all other creditors of an insolvent government, the bondholders will seek the best deal they can get, accepting that they may have to take less than what they are owed.

And so it was with Argentina. By 2010, 93% of its bondholders had swapped their defaulted bonds for new ones of lower value but with greater confidence that Argentina would make all payments on a timely basis, which it has done. Nevertheless, a few investors took another approach. After a default (or even before, if default is anticipated), bonds trade on financial markets at a small fraction of their face value. Many bondholders do not want to wait for the debt workout and are willing to sell them for a small percentage of their face value to be free to use those funds in other investments. The buyers are speculative investors. Most expect that when a new bond is offered in exchange for the defaulted bond, its face value will be higher than the price they paid for the defaulted bond and they then accept the swap. A few of the investors follow a different strategy. They try to collect the full face value of the original bonds through the courts; indeed, the speculators know that country will be better able to fully honour those old bonds once the majority of bondholders have accepted much-reduced claims on the sovereign government. This is what happened with some of Argentina's defaulted bonds.

In fact, the US courts have been quite sympathetic to the claims of bondholders and other creditors. They usually decide that the defaulting government should pay the speculators the face value of the bonds and all past due interest. However, getting a judgment against a government is not the same as collecting the money. The court will not allow the speculators to attach property that is part of the official functioning of the foreign government in the country, such as an embassy. However, if the government engages in 'commercial' activity, the creditors can seize commercial property when it is within the jurisdiction of the court or a friendly third country; e.g., if the government owns an airline, the speculators can attach it when it lands in their country. Argentina had privatised most of its commercial activities in the 1990s and so this route was not available for collecting what the court approved.

Giving the speculators a way to collect on judgments in their favour is where the US courts made their surprising reinterpretation of contract law. A standard clause in sovereign bond contracts is pari passu, which means 'equal footing' and is interpreted to mean that all the bondholders would be treated equally. It has long been understood that all the bondholders would thus have equal standing or equal priority in receiving payments from the borrower. NML Capital, the lead protagonist against Argentina, argued that pari passu meant that Argentina was obligated to pay all its current obligations to all its bondholders equally. The US court had said Argentina needed to pay the full face value and accumulated interest on the old bonds owned by NML Capital. The firm thus argued that the next time Argentina made its regular interest payment to its current bondholders (an unprotected commercial activity as interpreted by the courts), it would also have to fully pay NML.

This was a new interpretation of pari passu and the huge surprise was that the District Court accepted it, as did the Court of Appeals and as did the US Supreme Court, at least implicitly, as it declined to put Argentina's appeal on its docket. Argentina dutifully transferred the funds for its regular interest payment ($539 million) to Bank of New York Mellon to forward to each of its current bondholders; however, the District Court judge refused to allow that payment to be made without also paying the speculators. Argentina refused. As the interest due was thus not paid, Argentina was forced into a formal condition of default on its bonds at the end of July.

This reinterpretation of pari passu was so ludicrous that every sane legal authority knows it cannot be allowed to stand as a precedent and should not have been enforced on Argentina. Even the US government wrote an amicus curiae brief for Argentina, albeit at the appeals court stage. Several governments wrote amicus briefs at the Supreme Court stage, including France and Brazil. And the International Capital Market Association responded in August when it issued suggested new standard bond documentation which would make it explicit that pari passu means what everyone always understood it to mean and does not mean what the US judge said it meant.

Of course, it will take some 20 years for sovereigns to replace their maturing bonds with new ones having the proper interpretation of pari passu. In fact, the sad reality is that the vulture funds are very patient and usually collect their money in the end. They may do so again with Argentina after certain legislation expires at the end of the year. It has been one factor that prevented settlement thus far since it would require giving all Argentina's other bondholders the same deal as it gives the 'vultures'. It cannot afford that.

Nobody likes the vulture funds. Their 'winnings' come at the expense of the other bondholders as well as the debtor country. However, it is my understanding that many institutional investors (and probably rich individuals as well) from developed and developing countries gladly give them the money to pursue their financial strategies. The Argentina case has apparently been great advertising for this business [they probably also made money shorting Argentine bonds and collecting on credit default swaps (a kind of insurance) when the bond interest payment deadline passed end July].

This is too much. If not by international agreement at the UN, the international community should be able at the very least to stop future financial vultures through national legislation in the major capital market countries. After all, previous cases led to legislation to block further cases of the same type. In particular, Elliott Associates (the owners of NML Capital) collected on some Peruvian bank debt through Euroclear in Brussels in the 1990s, after which the Belgian Parliament adopted legislation to prevent misuse of Euroclear for this purpose again. Also, after Donegal International collected in the British courts in 2007 on some defaulted Zambian export credits that Romania sold them, the British Parliament adopted legislation to limit what a vulture fund could take home from a country that participated in the Heavily Indebted Poor Countries initiative, an internationally agreed process for comprehensive debt relief for a selected list of countries.

As most international sovereign bonds are issued in New York and London under their respective laws, should not those governments at least agree to propose legislation to their legislatures to outlaw vulture fund adventures against insolvent sovereigns? The argument could be, if you oppose the Argentine initiative at the UN to begin to collectively address a missing piece of the international financial architecture, at least take action at national level to stop vulture investors from interfering with debtor governments and their cooperating creditors.

A possible positive outcome

In fact, there seems to be sufficient dissatisfaction around the world with how sovereign debt crises are handled that an international reform initiative might gain enough support to lift off the ground. There is a sense in the International Monetary Fund (IMF), especially in the light of the Greek debt restructuring experience, that existing practices are not adequate and consideration of policy changes has been underway by the staff and in the intergovernmental Executive Board for over two years. In addition, multistakeholder meetings organised by the Financing for Development Office of the UN Department of Economic and Social Affairs, including in partnership with the Bank of England, have found considerable unease in the financial and academic communities as regards practices used for resolving sovereign insolvencies in developmentally and socially appropriate ways (see http://www.un.org/esa/ffd/msc/externaldebt/index.htm).

Moreover, the Norwegian government has supported the effort of a working group of experts at the United Nations Conference on Trade and Development (UNCTAD) that has engaged in a discussion of improvements in debt workouts. The working group has not offered any pre-elaborated proposals or solution, but has been drafting a set of principles that a debt workout mechanism should embody; e.g., it agreed at its last meeting that the principles of legitimacy and impartiality are important for a debt workout mechanism. Other principles discussed at earlier expert group sessions included efficiency, sustainability, transparency, ownership, fulfilling human rights obligations and providing adequate social protection (for details, see http://www.unctad.info/en/Debt-Portal/Project-Promoting-Responsible-Sovereign-Lending-and-Borrowing/About-the-Project/Debt-Workout-Mechanism/).

It is sometimes said that despite high-quality work in the secretariats of the United Nations, the UN is not the proper intergovernmental forum for addressing financial policy issues, including debt resolution policies. The people who make that argument generally point to the IMF as the proper forum, where indeed work is underway, as noted above. However, there is considerable and relevant intergovernmental and staff expertise at the United Nations for addressing sovereign insolvency. That is, the UN hosts a well-regarded intergovernmental forum on international insolvency at UNCITRAL, the United Nations Commission on International Trade Law. Working Group V of UNCITRAL is on insolvency law. It does not address sovereign insolvencies, however, but cross-border matters in mainly corporate bankruptcy. But it could address sovereign insolvency if the General Assembly requested it to do so (as per the personal opinion expressed to this author in the early 2000s by Jernej Sekolec, then the Secretary of UNCITRAL, now retired).

This suggests a possible strategy to improve debt workouts through the United Nations. While resolution 68/304 calls upon the General Assembly to specify a legal framework for resolving sovereign debt crises, it is doubtful that a consensus over a precise legal framework can be reached in the time available for negotiation before September 2015, especially in light of the lack of consensus over the enabling resolution itself. Recalling that an Assembly resolution that is adopted by vote has little effective international standing, the challenge is to gather in all member states at the UN to work together to reach a consensus text that reflects shared political priorities, which do exist.

A solution might thus be for the Assembly to adopt in 2015 by consensus and for further consideration a draft set of principles at a fairly broad level of generality, such as are being suggested in the UNCTAD working group. Although not itself a satisfying end point for discussion of debt policy reform, perhaps the consensus resolution could also request that UNCITRAL review the Assembly's proposed draft principles and devise more precise legal language that could best withstand challenges to their standing (having in mind the story of pari passu noted earlier).

UNCITRAL could also be asked to recommend modalities for implementation. Should it be through the drafting of a model law containing the legal framework that countries would then adopt into their domestic legislation, as proposed years ago by Professor Christoph Paulus of Humboldt University in Berlin? Or should it adopt a 'Fair and Transparent Arbitration Process', as advocated by several civil society organisations? Or would a voluntary mediation service be a more acceptable option to the parties involved in a sovereign restructuring, as proposed by the American lawyer Richard Gitlin and recently advocated in a project of the Center for International Governance Innovation in Canada? Or should there be something like a court for governments, as advocated by Jubilee South? Whatever its form, the implementation modality should be guided by the new legal framework. UNCITRAL could be asked to study the implementation options and report its views to the General Assembly, which could request that next steps be debated in a multi-ministerial, multi-institutional and multi-stakeholder follow-up process hosted by the UN, as had been envisaged at the original International Conference on Financing for Development in 2002.

In short, there is fairly wide international recognition that there is a problem and that there are various ways to address it. The international community acknowledged the problem and agreed to address it more than a decade ago when it agreed in the Monterrey Consensus that:

'To promote fair burden-sharing and minimize moral hazard, we would welcome consideration by all relevant stakeholders of an international debt workout mechanism, in the appropriate forums, that will engage debtors and creditors to come together to restructure unsustainable debts in a timely and efficient manner...'

The initiatives discussed at that time did not bear fruit and the problem remains. A new initiative has been launched in the UN. If it is nurtured, positive reform is possible. The international community agreed to a sovereign debt workout process once before, although it was in 1907 in the Hague Treaties, which included an agreement to settle sovereign insolvency through arbitration instead of gunboat diplomacy. More than a century later, Argentina's disappointment has pushed opened the door to reform a crack. A faint breeze begins to come into the room.                              

Dr Barry Herman (hermanb@newschool.edu) is with the Milano School of International Affairs, Management and Urban Policy, The New School, New York.

*Third World Resurgence No. 289, September 2014, pp 20-24