IMF proposals seek ‘more robust legal framework’ for sovereign bonds

Earlier this year, Argentina was forced into a fresh default after a New York judge ruled its government could not pay investors who had accepted a debt exchange following the country’s default in 2001 unless it also paid holdout creditors, those investors who had withheld their consent for restructuring in the hope they would be able to recover the full value of claims.

The IMF said “there is a recognition that, in circumstances where a sovereign and its creditors have reached the conclusion that a debt restructuring is necessary, the existing legal framework may not be sufficiently robust to prevent holdout creditors from undermining the restructuring process”.

Proposed reforms, which the IMF said have been backed by its executive board, include a modification of the equal treatment ‘pari passu’ clause used by US hedge funds to claim full repayment on Argentine bonds. The IMF said changing this clause would explicitly exclude the obligation to pay holdout investors.

IMF general counsel Sean Hagan said: “The primary motivation for the reform of this provision is, in fact, the litigation involving Argentina. In that case, the pari passu provision was interpreted by the New York courts as requiring rateable or pro rata payment to all creditors. So Argentina, as well as the bond trustee and other parties in the payment chain, were prevented from making any payments to those bondholders who had agreed to restructure their debt unless it also made payment in full to the holdout creditors. The concern, and this is a concern shared by many, not just by the IMF, is that this case may have systemic implications since it will enhance the holdout strategy in future cases.”

Hagan said the IMF had “embarked on a broad reform agenda in the area of sovereign debt restructuring”. He said: “An important element of that agenda is the strengthening of the legal framework that supports the restructuring process. It has been agreed that reform in this area should be market-based and, accordingly, we have been focusing on potential changes to international sovereign bonds contracts.”

The IMF has also recommended the inclusion of a more robust “collective action clause” that would bind all investors to a decision made by a supermajority of 75% of creditors if a country defaults and attempts to restructure its debt.

All of the proposals are “consistent with a number of the features of the clauses that were recently adopted by the International Capital Market Association”, which represents many major global financial institutions and sovereign issuers, Hagan said.

Hagan said: “There’s a broad recognition among the official sector, sovereign issuers, and creditors that, while debt restructuring is the exception rather than the norm, there may come a point at which it is in everyone’s best interests for a sovereign’s debt to be restructured. When that time comes, there is a risk that individual creditors might decide not to participate in a restructuring in the hope that they will be able to recover the full value of their claims.”

Hagen said that if holdout creditors “have a significant chance of recovering their claims in full, creditors who would otherwise have agreed to participate in the restructuring will become less willing to do so, even though it would be in the collective best interest of all creditors to agree to a restructuring as soon as possible”.

The modified pari passu clause that the IMF has endorsed is already being used by some sovereign issuers, Hagan said. “With respect to collective action clauses, Kazakhstan recently issued a Eurobond that includes for the first time the key features that were endorsed... this is a very significant first step and the task now will be to encourage more widespread adoption of the new clauses”.