Sovereign bond contracts:
a workshop at the Bank of England
Paul Bedford, International Finance Division, Bank of England
Improving the design of sovereign bond contracts is one way in which the arrangements for resolving sovereign debt
crises can be strengthened. In January 2005, the Bank of England hosted a workshop that allowed market
participants to review recent developments in contract design and consider the case for further innovation. This
short article summarises the main points of discussion.
ON 12 JANUARY 2005, the Bank of England hosted a Impetus for change
workshop on sovereign bond contracts. The event The workshop recognised that the recent shift in
aimed to facilitate discussion amongst market market practice to accommodate majority amendment
participants on whether and how innovation in the clauses in sovereign bond contracts issued under New
design of sovereign bond contracts could contribute York law constitutes a significant step forward.(1)
to strengthening further the framework for sovereign These clauses allow a super-majority (normally 75%)
debt restructuring. Those attending included: senior of bondholders to approve an amendment to the
officials from emerging market issuers of sovereign financial terms of a bond issue, and thus have the
bonds; legal experts; underwriters; providers of potential to act as particularly powerful instruments
trustee services; and representatives of the investor in facilitating orderly sovereign debt restructurings.
community.
Looking beyond majority amendment clauses, several
Suitable arrangements for restructuring sovereign workshop participants argued that there are a
bonds allow sovereign debt crises to be resolved more number of additional areas in which further
efficiently and reduce the risk of such crises contractual innovation could deliver tangible
undermining the stability of the international benefits. Others noted, however, that there is a risk of
financial system. Furthermore, a protracted and attempting to move too quickly in this area. For
disorderly restructuring process imposes example, majority amendment clauses in sovereign
significant costs on both the sovereign debtor and its bond contracts governed by New York law remain
creditors. The effective design of sovereign bond untested in crisis situations; therefore it is not yet
contracts can play an important role in ensuring that possible to assess with complete confidence their
restructurings are concluded as efficiently as overall impact and effectiveness.
possible.
Furthermore, there was general consensus that
Against this background, the workshop highlighted a contractual innovation is not the only way in which
number of areas where different interest groups hold the framework for sovereign debt restructuring can be
broadly similar views and useful progress was made in strengthened. In particular, there is scope also to
respect of identifying practical measures that could pursue the non-contractual approach embodied in
be taken to improve upon existing contractual the recently published Principles for Stable Capital
conventions. It was also apparent, however, that there Flows and Fair Debt Restructuring in Emerging Markets
are other areas in which more fundamental (hereafter, the Principles).(2) Most workshop
differences of opinion arise and where further participants acknowledged that there is a basic
discussion is warranted. complementarity between the contractual and
(1) A comprehensive summary of recent developments in the design of sovereign bond contracts can be found in Drage, J and Hovaguimian, C (2004), ‘Collective
action clauses (CACs): an analysis of provisions included in recent sovereign bond issues’, Bank of England, November.
(2) The Principles were published jointly by a number of emerging market issuers of sovereign bonds, the Institute for International Finance (IIF), and the
International Primary Markets Association (IPMA) in November 2004. See www.iif.com/data/public/principles-final_0305.pdf.
Sovereign bond contracts: a workshop at the Bank of England — Financial Stability Review: June 2005 101
non-contractual approaches to facilitating efficient hand, it can be argued that a creditor committee
debt restructuring, but opinions differed in respect of appointed under the terms of a contractual clause is
the extent to which the Principles would have a likely to have greater legitimacy than a committee
material impact on the behaviour of sovereign established by means of a voluntary agreement
debtors and their creditors. between a sub-set of bondholders.
Types of contractual innovation A potential advantage of the non-contractual
The workshop discussed three contractual approach relative to the contractual alternative is that
innovations that could improve the effectiveness of it would allow greater flexibility to address sovereign
the sovereign debt restructuring framework: debt crises on a case-by-case basis. For example, the
engagement provisions; the appointment of use of engagement provisions could, at least in
bondholder trustees; and aggregation clauses. principle, lead to a situation where a debtor with
multiple bonds outstanding is required to enter into
Engagement provisions restructuring negotiations with several creditor
There was broad consensus that dialogue and committees.(3) By contrast, a voluntary framework is
structured negotiation between a sovereign debtor more likely to allow for the establishment of a single
and its creditors can facilitate efficient debt committee tasked with representing creditors holding
restructuring. Although some workshop participants a range of different bond issues.
argued that negotiations are not strictly necessary
(on the theory that ‘take-it-or-leave-it’ exchange offers Bondholder trustees
can be equally effective), others considered that the The ability to enforce creditor claims through legal
absence of a suitable channel for debtor-creditor action makes an important contribution to
communication is likely to increase the likelihood of maintaining the stability of the sovereign debt market
creditors resorting to legal action and impose by disciplining the behaviour of debtors. But many
additional costs on all parties.(1) workshop participants also noted that, from an
efficiency perspective, co-ordinated litigation may be
Views differed, however, on how constructive preferable to bondholders pursuing their claims
debtor-creditor communication and negotiation individually. Furthermore, there can be benefits from
should be achieved. One option, advocated by a protecting sovereign debtors from aggressive
number of workshop participants, is to introduce litigation strategies employed by a minority of
engagement provisions into sovereign bond contracts. ‘hold-out’ creditors intent on securing more
But other participants preferred to rely on a favourable treatment in bilateral deals concluded
non-contractual (that is, voluntary) approach. In this outside the formal restructuring process.
respect, it is noteworthy that the Principles encourage
both sovereign debtors and their creditors to One possible means of addressing both these
negotiate restructuring deals in ‘good faith’. concerns is to appoint a bondholder trustee mandated
to represent the interests of the full population of
By requiring a sovereign debtor to negotiate with an bondholders. A trustee performs a role
elected creditor committee, engagement provisions complementary to that of the fiscal agent tasked with
can ensure that a single point of contact is managing (on behalf of the debtor) the process of
established between the two parties. But it was also making payments to bondholders. The appointment
recognised that these clauses are not in themselves of a trustee is standard for sovereign bonds issued
sufficient to deliver effective debtor-creditor under English law, but remains the exception for
engagement. A contractual requirement to negotiate bonds governed by New York law.
with a creditor committee may have little substance if,
as is typical, the committee does not have the power An English-law trustee holds an exclusive right to
to commit to a restructuring deal.(2) On the other initiate litigation against a sovereign debtor in
(1) Most recent sovereign debt restructurings have involved the debtor making a non-negotiable exchange offer to its creditors. See Box 2 in the accompanying
article Bedford, P, Penalver A and Salmon C, ‘Resolving sovereign debt crises: the market-based approach and the role of the IMF’ in this Review.
(2) A further consideration is how the costs incurred by the creditor committee are to be recovered. Among the small number of recent issues to include
engagement provisions, some have addressed this point directly, whilst others have not.
(3) In practice, this concern may be more apparent than real. For example, contractual engagement provisions could be designed in a way that allows for
cross-committee co-ordination.
102 Financial Stability Review: June 2005 — Sovereign bond contracts: a workshop at the Bank of England
respect of both accelerated and non-accelerated An acceleration threshold is not, however, a direct
claims;(1) therefore bondholders (including potential substitute for a trustee. Under English law at least,
hold-outs) are unable to take legal action individually. the appointment of a trustee ensures that a sovereign
By comparison, the power of trustees under New York debtor cannot be subject to multiple legal actions.
law is somewhat less extensive, with each creditor By contrast, acceleration thresholds leave open this
retaining the right to initiate litigation in order to possibility; in the event that a sufficiently large
recover missed payments (but not accelerated proportion of bondholders agree to accelerate, there
amounts). The appointment of a New York-law is no (contractual) mechanism for ensuring
trustee does not, therefore, eliminate the possibility co-ordinated legal action thereafter.
of a sovereign debtor being subject to numerous legal
actions initiated by bondholders acting More generally, workshop participants noted that
independently. there is also an open question concerning whether
protection against disruptive litigation would
Both English and New York-law trustees are required continue to be a material concern as majority
to act on behalf of bondholders collectively. amendment clauses become more prevalent in
Accordingly, the proceeds of any legal action brought sovereign bond contracts. Under the terms of these
against a sovereign debtor must be shared pro rata clauses, contractual amendments approved by a
among the full population of bondholders. In effect, super-majority of creditors holding a particular bond
the appointment of a trustee introduces a type of are legally binding on every holder of that bond.
‘sharing clause’ into sovereign bond contracts. Given Consequently, post-restructuring legal action is
this arrangement, a trustee can serve as convenient unlikely to be a viable option.
first point of contact for a sovereign debtor seeking to
communicate (or negotiate) with its bondholders. However, post-restructuring litigation is not the only
legal strategy available to creditors. Under the
Trustees also perform a number of other important doctrine of merger (as recognised in some
functions in respect of sovereign bond contracts. For jurisdictions), judgement creditors’ claims fall outside
example, an English-law trustee is typically able the original contractual framework;(2) therefore
unilaterally to approve corrections to manifest error individual bondholders may be able to pursue
in bond documentation. But there are also limits to pre-restructuring litigation as a means of avoiding the
the role of a trustee. In particular, a trustee normally possibility of being bound by a restructuring deal
does not have the power to make commercial concluded using, for example, a majority amendment
decisions on behalf of bondholders. clause. Increased use of these clauses is therefore
unlikely to eliminate fully the risk of disruptive
The potential benefits of bondholder trustees litigation.
notwithstanding, several workshop participants
argued that there are in fact a number of alternative Aggregation clauses
ways in which the design of sovereign bond contracts In practice, the vast majority of sovereign debt
could contribute to reducing the likelihood of restructurings involve a significant number of debt
disruptive litigation. For example, acceleration instruments. An ability to aggregate creditor claims
thresholds (through majority enforcement provisions) across multiple bond issues could therefore further
require a minimum percentage of bondholders to improve inter-creditor co-ordination and allow more
agree to accelerate a bond and therefore significantly restructurings to be completed by means of
constrain the ability of hold-out creditors to initiate amendments to the terms of existing bonds. There
litigation proceedings against a sovereign debtor. In are, however, currently few examples of aggregation
this respect, acceleration thresholds have the effect of clauses in sovereign bond contracts; gauging market
narrowing the distinction between sovereign bonds reaction to their use is thus difficult. Nevertheless,
for which a trustee is appointed and those issued some workshop participants forecast that the process
under a simple fiscal agency agreement (that is, of introducing these clauses would mimic recent
without a trustee). experience with majority amendment clauses —
(1) Following a missed payment, bondholders can, under certain conditions, accelerate a bond such that the full amount outstanding (principal and accrued
interest) is payable immediately.
(2) The term ‘judgement creditor’ refers to a creditor that has obtained a court ruling requiring the debtor to make payment.
Sovereign bond contracts: a workshop at the Bank of England — Financial Stability Review: June 2005 103
initial scepticism followed by general market Interpretation of sovereign bond contracts
acceptance. The workshop highlighted that there remain a
number of unresolved questions regarding the legal
It was also recognised, however, that there are many interpretation of sovereign bond contracts, most
open issues regarding the most appropriate design of especially in respect of the ability of creditors to
a contractual aggregation mechanism for recover payment due through the courts. As noted
sovereign bonds. One important consideration is to above, litigation plays an important role in imposing a
identify suitable creditor classes; it would not be degree of discipline on sovereign debtors. Yet market
appropriate, for example, to aggregate across participants currently have only limited experience in
secured and unsecured claims. Defining creditor this area — until relatively recently, legal action
classes is potentially most problematic in the against sovereigns had been rare.
context of pre-default debt restructurings
(where creditors would hold claims of different Over recent years, however, there has been an
maturity).(1) appreciable increase in litigation proceedings against
sovereign debtors, partly as a consequence of the
Recent debate on the design of the aggregation rapid growth in bond issuance by emerging market
clauses has been heavily influenced by the countries. Relative to the large banks that had
approach employed by Uruguay and the use of previously provided the majority of emerging market
issue-level voting thresholds in particular.(2) It can be finance, the population of bondholders is both larger
argued that a ‘true’ aggregation mechanism would and more diverse. The shift towards bond finance has
dispense entirely with issue-level voting. therefore introduced a broader range of creditor
However, the thresholds used by Uruguay play an interests and made effective inter-creditor
important role in mitigating the risk of a particular co-ordination more difficult to achieve. As a result,
bond being included in a multi-instrument the likelihood of individual creditors resorting to
restructuring deal against the wishes of a majority of litigation has increased.
the holders of that bond. In principle, this objective
could be achieved using a 50% issue-level voting In addition, a series of legal precedents has
threshold, but Uruguay opted to pursue a more contributed to an increased likelihood of creditors
conservative approach by setting the threshold being able to secure court judgements ordering a
at 662/3%. sovereign debtor to pay — examples include rejection
of the champerty defence(3) and restrictions on the
Uruguay first introduced aggregation clauses in a set of scope of sovereign immunity.
new bonds issued simultaneously as part of a
comprehensive debt restructuring concluded in There is, however, a crucial distinction between
2003. Consequently, it was relatively straightforward obtaining a court judgement against a sovereign
to define contractually the range of instruments debtor and enforcing that judgement. Attachment of
covered by the aggregation mechanism, a task that is sovereign assets has traditionally been very difficult,
likely to be more difficult where new bonds are issued although some judgement creditors have recently
outside a restructuring. One possible means of been able to find creative ways of enforcing their
overcoming this problem would be for sovereign debtors claims. One particular example is provided by the
to introduce medium-term note programmes (thus case of Elliott Associates versus Peru, in which the
establishing a means of issuing individual bonds under enforcement actions of the former led to Peru
standardised legal terms). Moreover, there was general agreeing an out-of-court settlement.
consensus that, in a legal sense at least, the
introduction of aggregation clauses into sovereign In attempting to enforce its claim against Peru, Elliott
bond contracts could be achieved in a number of Associates employed a legal argument based upon a
different ways. broad interpretation of the pari passu clause routinely
(1) After a default, all creditor claims are accelerated and thus have common maturity.
(2) A description of the aggregation clauses used by Uruguay can be found in Buchheit, L and Pam, J (2004), ‘Uruguay’s innovations’, Journal of International Banking
Law and Regulation, January. Near-identical clauses have been included in the new bonds issued by Argentina and the Dominican Republic as part of their debt
restructurings completed earlier this year.
(3) The law of champerty has the effect (when upheld) of prohibiting litigation in circumstances where the creditor concerned has acquired a claim with the
express intention of pursuing legal action.
104 Financial Stability Review: June 2005 — Sovereign bond contracts: a workshop at the Bank of England
included in sovereign bond contracts.(1) However, Looking ahead
most workshop participants considered the likelihood The workshop provided an opportunity for market
of this interpretation surviving further court scrutiny participants to consider the significance of increased
to be small.(2) Nevertheless, these participants use of majority amendment clauses in sovereign bond
anticipated that judgement creditors will continue contracts and discuss the advantages and
proactively to seek alternative ways of enforcing their disadvantages of a range of other possible
claims against sovereign debtors. At least three innovations. In these respects, useful progress was
possible approaches were identified: made and a number of areas of common ground
identified.
q appealing to ‘procedural’ (as opposed to
contractual) pari passu arguments based on The Bank of England believes that further innovation
judgement enforcement laws; in the design of sovereign bond contracts could
contribute to the development of a more efficient
q seeking to attach the overseas assets of state-owned framework for resolving sovereign debt crises. A
enterprises; and companion article in this Review discusses the role of
contractual innovation in the broader context of
q requesting international arbitration under the initiatives aimed at strengthening the framework for
terms of bilateral investment treaties.(3) crisis resolution.(5) The Bank also recognises,
however, that changes to existing contractual
Although there is some precedent for the first conventions will require the agreement of both
approach to be successful,(4) workshop participants emerging market issuers of sovereign bonds and the
acknowledged that it is currently difficult to predict investor community. Consequently, the Bank intends
whether any of these enforcement strategies will to build on the progress made at the workshop by
prove to be viable over the long term. continuing to encourage (and where appropriate
facilitate) discussion amongst market participants.
The workshop also noted the potential significance of
litigation proceedings currently pending against Welcome improvements to the design of sovereign
Argentina following its default in 2001. In particular, bond contracts have been made over recent years.
some creditor groups have employed innovative legal But it would be inappropriate to conclude that, for
strategies in their attempts to recover payment — example, the introduction of majority amendment
notable examples include the use of class action clauses represents a complete solution addressing all
procedures and the initiation of pre-restructuring potential sources of inefficiency in the sovereign debt
litigation. Against this background, it is possible that restructuring process. Further contractual
a number of important legal precedents will be set innovation, supported where necessary by other
over coming months. reforms to the international financial architecture,
could support the gradual reduction of these
inefficiencies.
(1) A standard pari passu clause dictates that the sovereign bond concerned ranks equally with all other unsecured and unsubordinated obligations of the debtor.
(2) Elliott Associates argued that the pari passu clause entitled it to a proportional share of any payments made by Peru on its (performing) external debt. These
payments were settled through the Brussels-based Euroclear system; therefore Elliott Associates presented its argument to the Belgian courts. A recent change
to Belgian law means that it is no longer possible for litigants successfully to enforce judgements in this way.
(3) Such arbitration could be initiated, for example, under the rules of the International Centre for Settlement of Investment Disputes (ICSID).
(4) In 2001, the Democratic Republic of Congo agreed an out-of-court settlement with Red Mountain Finance after the latter had obtained from a Californian
court a ruling with similar effect to that granted to Elliott Associates in its case against Peru. The court ruled in favour of Red Mountain on the basis of its
responsibility to aid the enforcement of judgements (that is, ‘procedural’ pari passu).
(5) Bedford, P, Penalver, A and Salmon C, ‘Resolving sovereign debt crises: the market-based approach and the role of the IMF’.
Sovereign bond contracts: a workshop at the Bank of England — Financial Stability Review: June 2005 105