Sovereign Debt Contracts Research Articles

On the Potential of Sovereign State-Contingent Debt in Contributing to Better Public Debt Management and Enhancing Sustainability Outcomes

AbstractSovereign state-contingent instruments (SCDIs) have been suggested as complements or alternatives to traditional sovereign debt instruments for a long time, but with little uptake. Markets for SCDIs have suffered from low liquidity and issues around measurement. This article argues that the escalating climate and ecological crises provide a strong rationale to reconsider the use of sovereign SCDIs as the physical and transition impacts of climate change and environmental degradation are increasingly altering the risk profile of sovereigns. The use of risk-linked sovereign instruments such as cat bonds or resilience bonds and embedding disaster risk clauses in sovereign debt contracts would be an important way for governments, especially in highly climate-vulnerable countries, to mitigate climate risks and scale up investment in resilience. Moreover, instruments such as sustainability-linked bonds that incentivise sustainability-oriented policies and investments could help to bring about better sustainability outcomes and contribute to greater debt sustainability. SCDIs can also play an important role in facilitating debt restructurings. The international community, supported by key institutions like the IMF and the major multilateral development banks, should make a concerted effort to promote the widespread adoption of sovereign SCDIs to support better public debt management, the climate-proofing of public finances, and the achievement of more ambitious sustainability outcomes.

Sovereign Debt and Moral Hazard: The Role of Collective Action and Contractual Uncertainty

The ambiguous phrasing of pari passu (equal treatment) clauses in sovereign debt contracts has long baffled commentators. We show that in the presence of asymmetric information about a sovereign borrower’s ability to pay, an uncertain clause gives rise to a collective-action problem among creditors that can reduce the sovereign’s moral hazard. By varying the clause, parties can calibrate a sovereign’s expected default costs and payments to creditors and thereby optimally trade off the sovereign’s moral hazard and (deadweight) default costs. As information asymmetry decreases, a pari passu clause becomes a coarser instrument for configuring creditors’ incentives and mitigating moral hazard. So that the door might not be shut in the face of borrowers. (Babylonian Talmud)

Restructuring Sovereign Debt by Incorporating Soft Law as Governing Law or by Reference

This paper, presented at the D-DebtCon 2020 sovereign debt panel, examines an innovative new contractual approach to help solve the holdout problem. That problem arises, for example, when certain hedge funds—known as vulture funds—buy distressed sovereign debt at pennies on the dollar and vote their holdings to block a restructuring plan unless they receive more than their fair share thereunder. Holdouts thereby can obstruct otherwise rational sovereign debt restructuring plans. Although, in principle, statutory and contractual solutions can solve the holdout problem, statutory solutions have not been politically acceptable and contractual solutions have been insufficient. This paper advances the arguments recently made in Soft Law as Governing Law, 104 MINNESOTA LAW REVIEW 2471 (2020), that parties to sophisticated business contracts, such as sovereign debt contracts, should be able to choose non-governmental rules, or soft law—in the case of sovereign debt contracts, the CIGI Model Law for sovereign debt restructuring—as the contract’s governing “law”. Choosing the Model Law as that governing law would help to facilitate aggregate supermajority voting, thereby solving the holdout problem.

Bringing Rule of Law and Fairness to the Dysfunctional World of Sovereign Debt: A Role for Canada?

Restructuring sovereign debt has long proved challenging: There is no formal regime for sovereign insolvencies similar to those that that govern domestic bankruptcy and insolvency and attempts to create one by international treaty have been met with political resistance. Currently, sovereign debt restructuring is governed by the debt contracts themselves along with the background law in the jurisdiction in which the debt is issued. Sovereign immunity also protects most state assets from seizure. These ad hoc restructuring processes are plagued by unpredictability, however, and there are incentives for individual creditors to “hold out,” demanding full repayment of their claims and thereby undermining a necessary restructuring. Judicial decisions in recent years regarding debt governed by New York law have only strengthened the hand of these holdout creditors. While modifications to standard terms in sovereign debt contracts can go some way towards improving the current situation, this paper proposes that a superior option is the adoption of a Model Law on sovereign debt restructuring by at least one appropriate jurisdiction. Under the Model Law approach, sovereigns could issue debt in a jurisdiction that has enacted a law providing for a fair, orderly, and predictable restructuring in the event that a sovereign’s debt becomes unsustainable. Due to its well-developed financial markets and reputation for the rule of law, this paper argues that Ontario, supported by Canada, would be an appropriate jurisdiction to enact such a law. This article further argues that a collaborative legislative approach between Ontario and federal Parliament would best ensure the constitutional validity, and therefore stability, of this novel and innovative proposed regime.

Financial Disputes in International Courts

The question of adjudication in international financial law has rarely been analysed comprehensively in the legal literature. This can probably be explained with the fact that, unlike in other areas of international economic law, there is no international financial court specifically designed to adjudicate international disputes between financial regulators, or between governments and financial institutions or investors. Moreover, the informality of regulatory cooperation through Transnational Regulatory Networks (TRNs), the use of soft laws to regulate international financial relations, and the presence of prudential carve-outs in international treaties was supposed to keep financial supervisory and regulatory authorities free from international scrutiny and to limit the judicial review of regulatory measures to a purely domestic exercise. Yet, financial measures are increasingly challenged in international investment tribunals, human rights courts, and regional courts. From 1995 to 2016, there have been more than 100 known international disputes on financial services, of which roughly two-thirds involved a supervisory measure such as the resolution or bankruptcy of an insolvent bank or the imposition of supervisory fines. The remaining claims mostly included violation of sovereign debt contracts, or emergency legislation affecting financial services. Investment arbitrations, in particular, are considerably on the rise. The increased number of regulatory disputes represents fundamental implications for the financial regulatory community in terms of domestic governance, regulatory cooperation, and global financial stability. This essay empirically investigates and maps for the first time the patterns of international adjudication in financial law, and comments on what the rise of international litigation means for the global financial architecture.

Domestic and External Sovereign Debt

Why do countries tend to repay their domestic and external debt, even though the legal enforcement of the sovereign debt contract is limited? Contrary to conventional wisdom, we argue that temporary market exclusion after default is costly. When the domestic financial market is characterized by a scarcity of private saving instruments, a government can partition its debt market into domestic and external segments, by restricting capital flows, to exploit its market power. The government's market power mitigates the problem of limited commitment, by making default a more costly option. Consequently, it extends the government's external debt capacity. We replicate the domestic and external sovereign debt for non-advanced economies, by unveiling their link to financial repression.

Sovereign Debt and Moral Hazard: The Role of Collective Action and Contractual Ambiguity

The ambiguous phrasing of pari passu (equal treatment) clauses in sovereign debt contracts has long baffled commentators. We show that in the presence of asymmetric information on a sovereign borrower's ability to pay, an uncertain clause gives rise to a collective action problem among creditors that can reduce sovereign moral hazard. By varying the clause, parties can calibrate a sovereign's expected default costs and payments to creditors and thereby optimally trade off the sovereign's moral hazard and (deadweight) default costs. As information asymmetry decreases, a pari passu clause becomes a coarser instrument for configuring creditors' incentives and mitigating moral hazard.

Don’t cry for Argentina (or other Sovereign borrowers): lessons from a previous era of sovereign debt contract enforcement

Recent court rulings effectively barred Argentina from international capital markets until she honored previous sovereign debt contracts. These rulings have been criticized by some in the legal community for possibly harming New York’s standing as a preeminent capital market and hindering developing countries’ ability to borrow. This article asks whether such criticism is warranted and notes that a similar enforcement mechanism was employed by the London Stock Exchange before World War I to deny sovereign borrowers in breach of their contracts access to international capital markets.The pre-World War I era provides us with clues into how the sovereign debt market could evolve in the wake of the Argentina rulings. In contrast to the dire warnings, capital markets have historically worked well when sovereign borrowers face sanctions. The existence of sanctions gave sovereign borrowers the means to credibly signal their intent to repay. By including contract clauses that made default costly, historical sovereign borrowers of less than pristine reputation were able to signal their good intentions and enjoy the benefits of cheap access to world capital markets.

Domestic and External Sovereign Debt

Why do countries tend to repay their domestic and external debt, even though the legal enforcement of the sovereign debt contract is limited? Contrary to conventional wisdom, we argue that temporary market exclusion after default is costly. When the domestic financial market is characterized by a scarcity of private saving instruments, a government can partition its debt market into domestic and external segments, by restricting capital flows, to exploit its market power. The government's market power mitigates the problem of limited commitment, by making default a more costly option. Consequently, it extends the government's external debt capacity. We replicate the domestic and external sovereign debt for non-advanced economies, by unveiling their link to financial repression.

Asset backed contracts and sovereign risk

A fundamental problem with sovereign default is the lack of a legal enforcement mechanism. Since the 1920s, there have been an ongoing set of initiatives undertaken by the League of Nations and the UNCTAD to set international laws on borrowing and lending standards, all of which have failed. To address the unenforceability problem, this paper proposes to use asset backed contracts where the usufruct of the asset transfers to the asset holder. Unlike conventional sovereign borrowing, there are international laws governing asset backed contracts which allow the international assets of a country to be seized. This paper exemplifies on the idea that asset backed contracts, which are also widely practiced in Islamic finance, can provide a solution to unenforceable sovereign debt contracts. The paper focuses specifically on Argentina which has defaulted twice in 13 years. If Argentina had utilized asset backed contracts prior to its 2001 debt default, it would have gained from the following advantages: higher debt-to-GDP ratios, larger welfare gains, lower probability of default and thus lower borrowing costs.

Olden Pari Passu in Scotland Lay

It is commonly argued that no one today seems to know what a pari passu clause is doing in a sovereign debt contract. This is a problem, for pari passu is one of the most prominently displayed covenants in such documentalia. Having an utterly ubiquitous and utterly misunderstood piece of legalese hanging around numerous multi-multi-million contracts can yield untold confusion and tribulations (witness the 2011-2016 Argentina episode, for instance). Some posit that if we only knew what the clause was intended to mean when it was first used, then we will know what it should stand for today. Thus was born a new discipline: pari passu paleontology. Several elite experts have been busy scouring the past history of sovereign debt trying to dig up the original pari passu. Here I make a humble contribution to the field. I have found a sovereign pari passu from 1707. Both the context surrounding this particular clause (the Treaty of Union between England and Scotland) and the apparent intended meaning of the legal wordage (payments equality) make for an attractive case study, with potentially significant (even if perhaps not entirely welcomed) lessons for today´s researchers and practitioners.

Don't Cry for Argentina (or Other Sovereign Borrowers): Lessons from a Previous Era of Sovereign Debt Contract Enforcement

Recent court rulings effectively barred Argentina from international capital markets until she honored previous sovereign debt contracts. These rulings have been criticized by some in the legal community for possibly harming New York’s standing as a preeminent capital market and hindering developing countries’ ability to borrow. This article asks whether such criticism is warranted and notes that a similar enforcement mechanism was employed by the London Stock Exchange before World War I to deny sovereign borrowers in breach of their contracts access to international capital markets.The pre-World War I era provides us with clues into how the sovereign debt market could evolve in the wake of the Argentina rulings. In contrast to the dire warnings, capital markets have historically worked well when sovereign borrowers face sanctions. The existence of sanctions gave sovereign borrowers the means to credibly signal their intent to repay. By including contract clauses that made default costly, historical sovereign borrowers of less than pristine reputation were able to signal their good intentions and enjoy the benefits of cheap access to world capital markets.

Evaluating the Euro CAC Experiment of 2013

On January 1, 2013, it became mandatory that every new sovereign bond issued by a member of the European Monetary Union include a new contract clause called a Collective Action Clause or CAC. This, we believe, constituted the biggest one-time change to the terms of sovereign debt contracts in history, impacting a market of many trillions of euros. And it was not just that the change was big in terms of the size of the market it impacted; it was big in terms of its impact on the documentation of each individual Euro area sovereign bond contract. To illustrate, prior to January 1, 2013, all of the terms of a local-law Irish sovereign bond fitted on about a page and a half; the full document was about three pages long. After January 1, 2013, the document was twenty pages long; almost all of that space taken by the new CAC term. In terms of words on the page, it was a big change. But did it do anything meaningful? And, more importantly, did it do what it was intended to do?

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

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.

Strengthening the Contractual Framework for Sovereign Debt Restructuring - The IMF's Perspective

This article discusses the impetus for, key features of, and recent experience in implementing reforms to international sovereign debt contracts. Recognizing the vulnerabilities in the existing contractual framework for sovereign debt restructuring, the IMF in 2014 endorsed reforms to collective action and pari passu clauses in international sovereign bonds designed to limit the scope for holdout creditors to undermine a restructuring. Progress in incorporating the enhanced clauses in international sovereign bonds has been rapid – with the majority of issuances now including these clauses. However, a substantial stock of outstanding bonds remains without these provisions. The IMF will continue to engage actively with its membership and the markets to further promote the inclusion of the enhanced clauses in new issuances and, where feasible, accelerate the turnover of legacy bonds.

Sovereign Debt Restructuring: A Model-Law Approach

Abstract Unlike individuals and corporations, countries indebted beyond their ability to pay cannot use bankruptcy laws to restructure unsustainable debt. The United Nations and the International Monetary Fund have attempted to propose treaties to enable that debt restructuring, but the political difficulties of reaching a worldwide consensus have stymied their efforts. This article argues that a model-law approach to restructuring unsustainable sovereign debt should be feasible and effective because the vast majority of sovereign debt contracts are governed by the laws of either the debtor-state or two other jurisdictions. Those jurisdictions individually could enact a model law to give struggling nations a real prospect of equitably restructuring their debt to sustainable levels. By enabling such debt restructuring, that enactment would also help to foster the norms required to facilitate the development of international treaties.

Victory or repudiation? Predicting winners in civil wars using international financial markets

We develop a method to estimate which side will win a civil war using data from international financial markets. The key insight we deliver is that, for typical sovereign debt contracts, the probability of debt repayment will equal the probability of victory in a civil war. We test our predictor for standard outcomes in civil wars, including when the incumbent government loses (the Chinese Nationalists), when a new government is installed by a foreign power and decides to repudiate debt (the restoration of Ferdinand VII of Spain), and when there is a secession (the U.S. Confederacy). For China, markets were predicting a Communist victory three years before it happened. For the U.S., markets never gave the South much more than a 40 percent chance of maintaining the Confederacy. For Spain, markets considered the restoration of Ferdinand VII as likely (probabilities above 50%) as soon as France declared its intention to send military forces to the area.

A Seniority Arrangement for Sovereign Debt

A sovereign's inability to commit to a course of action regarding future borrowing and default behavior makes long-term debt costly (the problem of debt dilution). One mechanism to mitigate the debt dilution problem is the inclusion of a seniority clause in sovereign debt contracts. In the event of default, creditors are to be paid off in the order in which they lent (the “absolute or “first-in-time rule). In this paper, we propose a modification of the absolute priority rule that is more suited to the sovereign debt context and analyze its positive and normative implications within a quantitatively realistic model of sovereign debt and default.

Pari Passu: The Nazi Gambit

As the ongoing court battle between the Republic of Argentina and NML Capital, Ltd. illustrates, the meaning of pari passu in sovereign debt contracts remains highly contested. This article presents what might be the clearest historical evidence of what the pari passu clause was understood to mean in the pre-war period. It examines Nazi Germany’s defaults of the Dawes and Young Loans during the 1930s. According to this historical evidence, the parties believed that the clause promised parity in payment across different creditor groups (in this context, the various tranches representing nationals of different countries) considered to be part of the same general undertaking. This article reports no evidence to support what may be the most commonly offered interpretation for the clause today — that the pari passu clause was intended to prohibit the sovereign from passing laws that would have the effect of involuntarily subordinating certain creditors. This article also finds no evidence to suggest that the pari passu clause was understood as entitling the aggrieved creditor to a unilateral right to block payments to bondholders who assented to a government’s restructuring proposal.

Pari Passu: The Nazi Gambit

As the ongoing court battle between the Republic of Argentina and NML Capital, Ltd. illustrates, the meaning of pari passu in sovereign debt contracts remains highly contested. This article presents what might be the clearest historical evidence of what the pari passu clause was understood to mean in the pre-war period. It examines Nazi Germany’s defaults of the Dawes and Young Loans during the 1930s. According to this historical evidence, the parties believed that the clause promised parity in payment across different creditor groups (in this context, the various tranches representing nationals of different countries) considered to be part of the same general undertaking. This article reports no evidence to support what may be the most commonly offered interpretation for the clause today — that the pari passu clause was intended to prohibit the sovereign from passing laws that would have the effect of involuntarily subordinating certain creditors. This article also finds no evidence to suggest that the pari passu clause was understood as entitling the aggrieved creditor to a unilateral right to block payments to bondholders who assented to a government’s restructuring proposal.