Sovereign Debt Contracts: Implications of Trust Arrangements for Financial (In)stability

Abstract

Market mechanisms alone seem to be insufficient to facilitate an effective interplay between sovereign debt actors in order to readjust their commitments in times of crisis. In this regard, the legal structure of finance has the potential to remedy the state of affairs. More precisely, this paper suggests that the trust arrangement can serve as an effective and efficient safety valve, within the meaning of the Legal Theory of Finance of Katharina Pistor, to overcome coordination problems, thus benefitting the sovereign bond market and debt restructurings in particular. In this sense, one might expect the trust arrangement to be properly structured in terms of rights and obligations of the parties involved. However, as this paper demonstrates by using the 2005 Argentine debt restructuring case study, the current flaws of the contract design and regulation preclude the optimal use of the trust arrangement. As a result, while most coordination problems are resolved, the agency problem emerges, amounting to a similarly dysfunctional debt restructuring mechanism except that the main negative outcomes are shifted from sovereigns to bondholders. In its main reasoning, the paper elaborates on the lack of fiduciary duties for trustees under New York law, which in turn hampers the correct application of the systemically important safety valve—the trust arrangement,—and hence legal intervention is necessary. Therefore, this paper suggests imposing higher fiduciary standards on trustees under sovereign bonds governed by New York law. One possible way of addressing the issue is to enact new regulation. Alternatively, private organisations, like the International Capital Markets Association, might be better suited to swiftly put the contractual framework in order.