An Overview of Sovereign Debt Restructuring
PARTICIPANTS IN
THE SOVEREIGN DEBT MARKET
Debtors
Multilateral Official Creditors (MOCs)
MOCs include the IMF, World Bank, and various regional development banks, such as the African Development Bank, the Asian Development Bank, and the Inter-American Development Bank. These international financial institutions play an important role in restructuring the debt of emerging economies by providing support, debt relief, and liquidity.
Creditors
HOLDOUT CREDITORS
Holdout creditors are often distressed debt investment funds that purchase defaulted sovereign debt on the secondary market at a fraction of the face value with the specific purpose of not participating in any restructuring and seeking to recover the full face value of the debt.
Preventing the sovereign debt restructuring is generally not in the interests of the holdout creditor; indeed, once a restructuring has been completed, the sovereign is in a better financial position to meet their demands. Rather, their aim is to receive a better return or be paid to sell out of their bond position. Holdout creditors will use litigation to obtain judgments and seize the sovereign’s assets abroad where they can, in an attempt to pressure sovereigns to pay up.
Bilateral Official Creditors (BOCs)
BOCs mainly consist of other sovereign states—the most influential grouping of these formed the Paris Club to coordinate a collective approach to debt restructuring discussions. China has become a significant bilateral lender to low-income countries, tripling its overseas lending since 2008. These low income countries now owe 37% of their bilateral debt to China as compared to 24% to the rest of the world. Importantly, China is not a member of the Paris Club.
Commercial (Private) Creditors
Commercial (Private) Creditors encompass a broad group, which can include banks, institutional investors (investment funds including hedge funds, pension funds, and insurance companies), suppliers, trade creditors, and individuals. Each can present their own challenges: certain aggressive investment funds with a low basis may be prepared to hold out or otherwise disrupt the restructuring process to extract value, while retail investors may be less able to bear losses.
RECENT RESTRUCTURINGS
Puerto Rico:
The Commonwealth of Puerto Rico exited bankruptcy in March 2022, almost five years after officially entering bankruptcy relief proceedings.
The restructuring was uniquely complex, involving numerous creditors and SOE debtors, and exacerbated by various social and humanitarian crises.
Ecuador:
Ecuador recently reached a restructuring deal for $4.4 billion of debt with China, again demonstrating China’s increasingly active role as the world’s largest bilateral sovereign creditor.
Previously, in 2020, Ecuador completed a remarkably quick restructuring process involving multiple creditors. This was in large part due to the successful use of aggregated CACs to block the action of small groups of creditors.
Argentina:
Argentina had successfully restructured over $100 billion in sovereign debt by 2020. This restructuring effectively used aggregated CACs to accelerate the restructuring process, albeit their use being at times controversial amongst creditors.
Another restructuring deal of $45 billion of debt was reached with the IMF in January 2022, although given socioeconomic and political tensions, the situation remains volatile.
Zambia:
Zambia applied to restructure its sovereign debt in early 2021, becoming one of the first countries do so under the G20 Common Framework.
Under the Framework, an Official Creditor Committee was formed, notable for being co-chaired by China and France. The Committee’s agreement to negotiate restructuring has allowed for an IMF relief package and signalled potential future co-operation between China and traditional Western bilateral lenders.
Ghana:
Ghana, economically damaged by COVID-19 and high inflation, has been forced to turn to the IMF for assistance. However, the nation also owes a significant portion of debt to Commercial (Private) Creditors, who have signalled a reluctance to enter negotiations.
A staff-level agreement has recently been reached with the IMF, constituting a $3 billion Extended Credit Facility and a series of economic policies and reforms. Irrespective of the final outcome, the crisis exemplifies the issues that many Sub-Sahara African nations may face in the coming months and years.
Ukraine:
Ukraine came close to default in August 2022, before creditors agreed a 2-year payment freeze. However, with an economy in crisis and escalating loan amounts, a future default remains possible irrespective of the speed with which the Russian invasion is resolved.
Additionally, the central government has guaranteed the debt of several SOEs that are themselves in distress. Although the SOE creditors have, for now, agreed to a similar payment moratorium, future action on this debt could potentially push the sovereign itself into default.
Sri Lanka:
Sri Lanka has among the highest debt-to-government revenue ratios in the world, at more than 1,000%. Debt payments were halted in April 2022, constituting the first default in the nation’s history and causing significant socio-political turmoil.
The country has secured World Bank relief and is nearing the end of discussions with the IMF, but has had to offer major concessions, including dramatic reductions in the budget deficit and a change in status to a low income country.
State-Owned Enterprises (SOEs)
SOEs sometimes issue debt, which is guaranteed by the sovereign. Where these entities default, there is the very real risk of simultaneously destabilising the sovereign itself and it then defaulting. These guarantees can also cause issues during a restructuring process, where the creditors’ interests may not align with those of creditors to the state itself.
Sovereign
The sovereign will be the issuer and debtor. Uniquely, the sovereign will not have the benefit of an insolvency regime, meaning the debtor cannot be discharged from bankruptcy and must reach a consensual settlement with all creditors. The sovereign debt remains a liability of the state regardless of political change, which it must pay or face consequences including litigation, a seizure of its assets, and an inability to participate in the debt capital markets.
Within the sovereign there can be players with differing objectives, such as a politically driven ministry
of finance versus a central bank more focused on financial stability.
The Paris Club is an informal grouping
of 22 key creditor countries (and some ad hoc members), that coordinates to resolve sovereign debt crises.
Over the last 60 years, 433 successful negotiations have been completed with 90 countries.
Significantly, the Paris Club excludes large BOCs such as China; however, some co-operation has occurred in
the past.
Click the orange dots to read about each region
The period of relatively stable sovereign debt markets is over.
Growing numbers of sovereigns are either close to defaulting on bond payments or have already done so. 135 countries are “critically indebted” according to the Global Sovereign Debt Monitor 2022, and the twin crises of COVID-19 and the war in Ukraine have increased instability. There is also increased financial pressure on economies which are dependent on tourism and struggling to afford energy imports.
Unlike corporate debtors, there is no insolvency regime applicable to countries; however, there are a number of features that are common to sovereign debt restructurings, which we have set out below.
Trigger Event
The circumstances giving rise to the need to restructure can vary, including financial distress, an inability to pay maturing debt, lack of liquidity, political upheaval, or strategic decisions.
Announcement
Typically, an announcement will be made by the sovereign, either post-default or pre-emptively, putting creditors on notice that a restructuring is needed.
Restructuring “Envelope”
The sovereign debtor, either with financial advisors and/or the assistance of an MOC, such as the IMF, will seek to determine the overall debt relief required, conduct a financial sustainability study, and identify liquidity needs. The sovereign will prepare restructuring proposals setting out the relief sought and how the relief can be implemented, identifying creditor groups to be approached.
Negotiations
The restructuring proposal will be evaluated and considered by relevant creditor groups, who may form ad-hoc committees. How the debt relief burden is to be shared across different categories of creditors often results in prolonged discussions and negotiations. Support will be required across the creditor spectrum and, depending
on the terms of the underlying documents, this could require consent of all lenders under a financial instrument, presenting opportunities for holdout creditors.
Implementation
Once an agreement has been reached, there are three main tools available to restructure the debt.
First, the maturity dates for either principal or interest amounts falling
due can be lengthened or a grace
period provided ("amend and extend").
Second, the interest rate on the debt can be reduced (a “coupon adjustment”).
Finally, the actual principal amount
of the debt owed can be reduced (a “principal haircut”).
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THE PROCESS
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Due to the impact holdout action can have on the restructuring process, the economic and social stability of the sovereign, protracted litigation, and delayed debt relief, a number of approaches have been developed to counteract these creditor actions:
PREVENTING HOLDOUTS
Collective Action Clauses
Legislative Measures and Protocols
One of the most common ways to address holdout creditors is the use of Collective Action Clauses (CACs). Originally designed to allow a majority of bondholders (typically 75%) to agree and bind the remainder of bondholders in the same issuance to a restructuring, CACs have now developed into a sophisticated tool operating across series of bonds to help facilitate restructurings and prevent holdout creditor actions. The following table sets out the most common types of CACs seen in sovereign debt bonds.
It is worth noting that the EU will require bonds issued in the euro area to use single-limb CACs from January 1, 2023. Increasingly, bond documents provide for a menu of choices, giving the sovereign flexibility to choose from all three options.
These new CACs allow the sovereign debtor to modify or restructure multiple series of bonds without a majority of creditors in each series needing to agree. This makes any potential holdout far more expensive and difficult to achieve.
The UK’s Debt Relief (Developing Countries) Act 2010 (the “UK Act”) was introduced to assist Heavily Indebted Poor Countries (HIPCs) and limits recoveries in line with any agreed restructuring of the sovereign’s debt. The UK Act was limited in scope and time and is not available for non-HIPC countries; therefore, it is not very relevant to current or upcoming sovereign debt restructurings.
Contractual protections such as CACs are only useful to the extent they are incorporated in debt documents, and there remains outstanding sovereign debt which does not contain these protections. As a result, and to prevent or otherwise make aggressive holdout creditor actions unattractive, certain countries have enacted national anti-holdout creditor legislation. Belgium, France, and the UK have enacted legislation, the US has considered federal legislation, and a bill is being considered by
the United States.
United Kingdom
The new proposed amendment to New York’s banking law would override contractual terms to introduce a CAC style feature. The law would allow a sovereign debtor to propose
a restructuring plan to creditors, which if approved by two-thirds of the creditors in value and one-half of the total number of creditors would bind all creditors. Given
New York law is the choice of law for many sovereigns and the retrospective application of the legislation, the impact on future restructuring could be significant.
United States
International financial institutions and the likes of the G20 have introduced guidelines and protocols aiming to increase transparency and regulate creditor behaviour. The G20’s Common Framework seeks to set out a framework for restructuring debt in line with Paris Club principles and to ensure comparability of treatment across creditor groups. The IMF has the Sovereign Debt Restructuring Mechanism providing a blueprint for restructurings. However, these are not binding principles, especially in relation to Commercial (Private) Creditors where the risk of holdout is greatest.
International Protocols
Legislative Measures and Protocols
Collective Action Clauses
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