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					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.
                                                                                   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.
                                                                                   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

                                                   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
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

(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 (perfoming) 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