Strengthening collective action clauses: catalysing change—the back story

Key points

• The year 2014 witnessed the advent of new and strengthened collective action clauses (CACs) in foreign law sovereign bonds. These new clauses hold the promise to significantly strengthen the orderliness and predictability of the contractual market-based framework for the sovereign debt-restructuring process. This article looks at how these new CACs came about.

• The new CACs were borne from a process undertaken by an informal ‘Sovereign Debt Roundtable’ grouping that was convened, chaired and strategically led by US Treasury staff over more than one-and-a-half years. The inclusiveness of the Roundtable, the deliberative process, which was followed and the leadership and backing of the official community were integral to bringing about the private sector and success.

• The Roundtable’s deliberations built heavily upon earlier Treasury work to advance CACs, in particular during the 2002–2004 period. But the new clauses go further than the bond-by-bond clauses that were the focus from 2002 to 2004, as they allow in certain defined conditions the votes of different bond issues to be aggregated into a single up or down vote on the issuers’ restructuring proposal.

• In this regard, the new clauses reflect the continuity in the US approach under the Bush and Obama Administrations to promoting an orderly and predictable sovereign debt-restructuring process based upon the contractual framework, in addition to US opposition to statutory approaches. But they also represent innovation under the Obama Administration in advancing and buttressing the US approach.

 … in order to strengthen the orderliness and predictability of the sovereign debt restructuring process, we welcome the international work on strengthened collective action and pari passu clauses. We call for their inclusion in international sovereign bonds and encourage the international community and private sector to actively promote their use.

       G20 Leaders’ Communique; Brisbane, Australia; 16 November 2014

We welcome Mexico’s leadership with its successful issuance of a bond with new and innovative collective actions clauses under New York law. These new clauses will strengthen the sovereign debt restructuring process, and we encourage other nations to follow suit.

            Secretary of the Treasury Jacob Lew, 19 November 2014

We look forward to upcoming discussions around the International Capital Market Association’s (ICMA) proposal on possible means to reinforce collective action clauses in sovereign bonds…

         G20 Finance Ministers; Cairns, Australia; 21 September 2014

… ICMA recently published revised collective action clauses for sovereign debt that permit more orderly workouts and lower the chance of spillovers. These clauses … now allow for aggregation across many different debt issues, avoiding the need to vote on each loan one by one.

              John B. Taylor, Wall Street Journal, 9 July 2015

1. Introduction

The late autumn of 2014 witnessed the advent of new and strengthened collective action clauses (CACs) in foreign law sovereign bonds. These new clauses hold the promise to significantly strengthen the orderliness and predictability of the contractual market-based framework for the sovereign debt-restructuring process. They were born from a process that was convened, chaired and strategically led by Treasury staff over more than one to one-and-a-half years. ¹ The group working on the new clauses included issuing country representatives, inter alia from Mexico, Uruguay, Brazil and Turkey; leading UK and US sovereign debt legal experts; an array of market participants and academics; other official actors, including from France, the UK and Germany; and the IMF. In particular, this informal ‘Sovereign Debt Roundtable’ grouping also included Mexico’s debt manager and representatives from the London-based International Capital Markets Association (ICMA), an association representing some 500 firms from the international financial community, among others. The inclusiveness of the Roundtable, the deliberative process, which was followed and the leadership and backing of the official community were integral to bringing along the private sector and success.

The Roundtable’s deliberations built heavily upon earlier Treasury work to advance CACs, in particular during the 2002–2004 period. But the new clauses go further than the bond-by-bond clauses that were the focus from 2002 to 2004, as they allow, in certain defined conditions, the votes of different bond issuers to be aggregated into a single up or down vote on the issuers’ restructuring proposal. In this regard, the new clauses reflect the continuity in the US approach under the Bush and Obama Administrations to promoting an orderly and predictable sovereign debt-restructuring process based upon the contractual framework, in addition to US opposition to statutory approaches. But they also represent innovation under the Obama Administration in advancing and buttressing the US approach.

2. The context—impetus for a renewed reform effort

The US Treasury, in a speech by the then Under Secretary John B Taylor, outlined its support for the decentralized, market-oriented contractual approach to sovereign debt restructuring in 2002. ² Around that time, a G-10 working group, chaired by Randal K Quarles, then Assistant Secretary of the Treasury for International Affairs, and including leading sovereign debt lawyers, began work on developing CACs for inclusion in foreign law sovereign bonds. ³ In 2003, building on the ‘Quarles Report’, Mexico launched the first CACs pursuant to New York law. Mexico’s issuance solved the first mover problem, there was no observable pricing impact, and CACs overnight became the norm in the New York market. ⁴ Importantly, though, the CACs applied only to each individual bond.

During this period, the IMF advocated a statutory approach to sovereign debt restructuring. The Fund in essence reasoned that in a domestic setting, all unsecured creditors were bound into the restructuring deal through the bankruptcy process. Since there was no analogous international mechanism to bind similarly placed creditors into the restructuring through a single vote, there was a gap in the global financial architecture that should be filled through the creation of a ‘Sovereign Debt Restructuring Mechanism’ (SDRM). ⁵

Treasury was sceptical that the SDRM could be made to work in practice. There were concerns about politicization of the mechanism. There were questions about the possible impact on official debt. There was no appetite for pursuing an international agreement that could result in a supranational body having the authority to supplant core US sovereign decision making or judicial authority. There was the basic judgement that there would be little Congressional support for any amendment to the IMF Articles needed to implement SDRM. In contrast, the advent of CACs offered the promise that the contractual framework could be used to better mimic domestic bankruptcy proceedings and bind creditors.

In 2012, two important developments occurred, raising questions about the continued viability of the contractual framework to promote the orderliness and predictability of the sovereign debt-restructuring process and giving rise in some quarters to renewed calls for re-consideration of SDRM or statutory approaches more generally. These developments, left unaddressed, also had important implications for New York’s continued role as a major financial centre for the issuance of foreign law bonds.

• Long-standing debates about the meaning of the ‘ pari passu ’ clause in sovereign law bonds were underscored in judicial rulings. Many sovereign debt lawyers had long felt that the pari passu clause simply meant that the legal ranking of an instrument was equal (and not subordinate) to a borrower’s other debt instruments. Others, for over a decade through a novel interpretation of the clause, contended borrowers could be compelled to pay all of their obligations on a ratable basis. With US federal court rulings in New York supporting the latter interpretation, clearly the meaning of the ‘ pari passu ’ clause could no longer be considered settled. ⁶ Importantly, these legal challenges were not arising in the context of just one country; rather, there had been a substantial increase in creditor litigation over the past two decades impacting countries across the globe. ⁷

• While bond-by-bond CACs had become the market practice in New York since 2003, the limits of this ‘per series’ approach became clear in the case of the Greek debt exchange. Of the 36 bond issuances governed by English law that included CACs and could partake in the debt exchange, only 17 were successfully restructured using CACs, accounting for 30 of the total value of Greek debt governed by foreign law. ⁸

3. Substance and the process: creating and managing the sovereign debt roundtable

In early 2013, against the background of these emerging questions about the ability of the contractual framework to continue delivering orderly and predictable outcomes, as well as renewed interest in statutory approaches, especially in the United Nations, Treasury staff convened a roundtable of governmental and private sector experts and interested parties to discuss potential changes to clauses in sovereign bond contracts. The effort was premised on the US retaining its long-standing reservations about statutory approaches, and instead examining what changes in the ‘ pari passu clause’ and in ‘bond aggregation’ could strengthen and impart renewed vigour to the contractual framework.

Equally, the effort was premised on seeking pragmatic, targeted and concrete results, but not engaging in a meta-debate about broad strategic or conceptual approaches. At the outset, Treasury staff made clear that the USA did not support work on statutory approaches. For their part, the IMF representatives also made clear that the Fund had no intention of pursuing work on statutory approaches and it would be regardless infeasible to do so without the full support of the institution’s Executive Board, including major shareholders.

At a kick-off meeting in April 2013, on the margins of the IMF/World Bank Spring Meetings, the Roundtable launched into a discussion of the evolution of the sovereign debt-restructuring process over the prior decade, recent ‘ pari passu ’ litigation and its implications and how ‘aggregation clauses’ could be used to help overcome some of the problems posed by bond-by-bond voting and increased creditor litigation.

Private sector participants discussed how recent court ‘ pari passu ’ rulings could complicate the sovereign debt-restructuring process and how ‘ pari passu ’ language had taken on many disparate forms in contracts over the years. They were concerned about the consequences of the ‘ratable payments’ interpretation of the pari passu clause for the majority of creditors. With respect to aggregation features, there was a lengthy discussion of the Greek restructuring, and a view that the Greek foreign law bond restructuring was far less successful, because of the bond-by-bond collective action feature, than the Greek domestic law-governed bond restructuring. Some participants advocated developing ideas on aggregation across foreign law sovereign bonds so that there could be one vote to modify an entire series of bonds. However, it was also underscored that developing aggregation features could have important implications for inter-creditor equity considerations.

Against this background, a number of key points were agreed at the meeting, in turn charting the path forward for the Roundtable:

• Modifications to contractual clauses should be developed to address the emerging issues that had complicated the sovereign debt-restructuring process.

• Clarity was needed on pari passu clauses to dispel confusion and provide legal certainty. The clause should be seen as an ‘equal ranking’ clause; the ‘ratable payments’ interpretation of the clause was not the intended meaning.

• Aggregation features in bonds, especially aimed at allowing one vote to modify a series of foreign law bonds, could represent a useful innovation to enhance the restructuring process, provided that strong safeguards were also incorporated to protect the rights of all creditors.

At a second meeting in October 2013, again on the margins of the semi-annual IMF/World Bank meetings, the Roundtable reconvened to continue its discussions on pari passu clauses and aggregation.

The group reviewed an options paper on the ‘ pari passu clause’. ⁹ In the end, the Roundtable reached several conclusions on the pari passu clause and narrowed down consideration to two of the options, both of which were seen as offering a plausible path forward:

• There was concern that the clause had resulted in significant litigation over the past decade, complicating the sovereign debt-restructuring process, and that the likelihood was for continued increases in creditor litigation in coming years.

• Several lawyers in the Roundtable in particular felt that given the confusion raised by the clause over the years and its uncertain meaning, the pari passu clause should be simply eliminated from bond contracts.

• However, others questioned whether market participants would readily accept elimination of the clause, and thus proposed retaining a rewritten version that disavowed the ratable payments interpretation of the clause. They pointed to market inertia as well as noted that retaining such a modified version of the clause would still protect against the risk of involuntary legal subordination.

• Participants agreed that the Roundtable needed to come to a consensus on pari passu to provide a basis for market acceptability for a first mover.

The discussions on aggregation, in contrast, entered more of an exploratory realm. The Roundtable agreed that a key policy goal of constructing an aggregation framework was to reduce the scope for obtaining blocking positions, provide the sovereign with greater flexibility and at the same time protect against possible abuse or oppression of the minority by sovereigns. While there was wide acceptance of the concept of aggregation in principle, it was also recognized that to achieve these goals, there were numerous design details to be worked out with consequential legal ramifications and an enormous bearing on market acceptability. In wrapping up the second meeting, the Roundtable agreed to further pursue the one-limb option and its requisite features and come to a conclusion on the future of the pari passu clause. The IMF also expressed interest in pursuing further work on the contractual framework, using the Roundtable’s work as a foundation to inform its activities.

• An initial discussion focused on whether to use a ‘one limb’ aggregated voting structure, or a ‘two limb’ structure with an aggregated and a per series vote. Several European officials supported a ‘two limb’ structure as this approach had already been enshrined in the ESM treaty, developed and adopted within the euro-area. The rest of the Roundtable wished to explore whether a suitable ‘one limb’ framework could be developed, and felt an appropriate aggregation clause could further reduce incentives for creditor litigation. ¹⁰ One participant offered the insight that an important feature of a one-limb aggregation structure was that it would lessen the chances that a creditor—that might wish to vote against the proposal, but be willing to accept it should the requisite majority decide to do so—would ‘accidentally’ be kept out of the restructuring.

• The Roundtable began to delve into the kinds of protections that would be essential to protect against abuse of the minority. Most significantly, the Roundtable agreed that there should be a high voting threshold for one-limb aggregation, and that all participants in an aggregated vote should be treated the same.

• Participants also agreed that the scope of aggregated debt should be confined to foreign law sovereign bonds, and thus differ from the European CAC framework, which did not differentiate between foreign and domestic law bonds.

In discussions in early 2014, including conference calls, and at a third meeting in April, the Roundtable reviewed a model aggregation clause ¹¹ and bore down on achieving concrete results. In wrapping up this meeting, the Roundtable also welcomed ICMA’s proposal to develop model pari passu and aggregation language and conduct a public consultation. ¹²

• To address the question of which pari passu option to pursue and given the view that eliminating the clause might not be seen as acceptable by all market participants, the Roundtable agreed to back model pari passu language that disavowed the ratable payments interpretation.

• The Roundtable further agreed that aggregation, allowing for a single cross-series vote with strong safeguards, along with a bond-by-bond restructuring option, would help promote the orderliness and predictability of the sovereign debt-restructuring process. With respect to safeguards, it was agreed that: ‘voting thresholds’ should be set at a level which an aggregated cross-series modification vote could only succeed with the support of a large super-majority (ultimately 75 per cent of the eligible outstanding principal); single-limb aggregation would be limited to ‘bonds governed by foreign law’ (outside of the euro-area, which retained its two-limb structure for foreign and domestic bonds); ‘uniform applicability’ would provide for an identical offer requirement for any cross-series vote; ‘robust disenfranchisement provisions’ would exclude bonds controlled by the issuer from the vote; and ‘enhanced transparency and information disclosure’ would be required such that the issuer would need to disclose its overall restructuring plan, including its proposed treatment of other groups of creditors and claims, as part of its offer.

In subsequent months, ICMA’s model clauses became the new market standard. The IMF staff proposed to prepare a staff paper for the IMF Executive Board to endorse the key features of the model pari passu and aggregation language. ¹³

4. Subsequent developments in 2014

The third and last meeting of the Roundtable was by no means the end of the process. It was critical to develop a strong legal and market consensus behind the new clauses in order for a ‘first mover’ to move without facing market turbulence. Roundtable participants dedicated themselves to this task over the course of the remainder of the year.

Both an initial and final ICMA draft of proposed model clauses was provided to Roundtable participants for comment before being circulated to market participants and their finalization. While the underlying provisions of the ICMA model clauses were the same for both the New York and London markets, textual adaptations were required to conform to the practices of each market.

In furthering the dissemination of information about the new clauses and enhancing their acceptance, outreach gatherings were held with leading sovereign debt legal practitioners in both New York and London. ¹⁴ Treasury staff also conducted outreach with market participants. In particular, staff met with buy-side representatives in a series of meetings with leaders of the New York-based emerging market asset management and hedge fund communities, and also informally reached out to several London-based fund managers.

Roundtable participants also conducted outreach with debt managers in potential emerging market sovereign bond issuing countries, especially Latin America, that had not partaken in the working group.

The IMF played an instrumental role as well. The outreach efforts were reinforced by IMF staff in a series of meetings and bilateral discussions with public debt managers. On the basis of a paper prepared in large part by the Legal Department of the IMF, the IMF Board also endorsed in the fall of 2014 the widespread use of modified pari passu clauses in new international sovereign bonds so as to enhance legal certainty and consistency across jurisdictions. The Board noted the broad support of stakeholders for introducing CACs with robust aggregation features, and in particular considered the ‘single limb’ clause with appropriate safeguards along the lines of those put forward in the model ICMA clauses as a significant contribution to the sovereign debt-restructuring process. ¹⁵

In addition to the IMF Board’s support, the enhancement of the market-based contractual framework also received the strong endorsement of the wider official community. The communiqués of the G20 Finance Ministers and Central Bank Governors meeting in Cairns, Australia in September, as well as the G20 Leaders’ Meeting in Brisbane in November, both explicitly backed the strengthened CACs. ¹⁶

Most significantly, however, countries began to issue sovereign bonds with the new clauses. In particular, Mexico in November, around the time of the Brisbane Summit, undertook the first public offering with the strengthened CACs under New York law, selling $2 billion in 10-year bonds amid strong demand and locking in the lowest rates in Mexican history. Showing the same leadership as in 2003, the Mexican issuance with new CACs overcame the first mover problem and faced no pricing impact whatsoever. Mexico’s issuance was facilitated by the participation of its Finance Ministry’s debt manager, Alejandro Diaz de Leon, in the Roundtable. Around this time, many other countries from every quarter of the world followed suit—Kazakhstan in fact was the first mover at the global level, leading the way in the London market.

5. Ongoing challenges

While the advent of the new CACs is a major achievement, it is not a panacea and much work remains to be done to strengthen the contractual framework.

• The inclusion of new CACs in bonds will address the future stock of sovereign issuances, but it will not address the large outstanding existing stock. As noted by the IMF, that stock is roughly $900 billion, and it will take 10 years for approximately 70 per cent to mature. This process could be quickened, however, by voluntary ‘liability management operations’ (LMOs). Some market participants are known to be considering launching possible LMOs.

• The take-up of the new CACs so far has been extremely strong in the New York market, which has a heavy Latin focus. Take-up in London issuances, which have more of an African and Asian focus, has been strong but not as robust. Further outreach is generally needed, but especially for the London market. ¹⁷

• Several issuers have found it easier to re-open existing shelf offerings, thus rolling over or raising funds in several hours, rather than undertaking the more extensive work and cost of a new global offering. But in time, such countries will likely use new registration statements, encompassing the new clauses. Peru has already demonstrated this reality.

• Debates continue in some quarters about whether the form of creditor/issuer engagement after a restructuring should be contractually pre-specified through the required use of a ‘creditor committee’ structure, including one in which the borrower commits to recognize a committee and pay its costs. This debate was not addressed by the Roundtable, which was focused from the start on very specific shortcomings in two contract provisions ( pari passu and aggregation).

• Some country representatives, especially at the United Nations, continue to push for development of a statutory mechanism, even though the statutory approach has found little support in the IMF and G20, and has been rejected by the USA and UK, the key centres in which over three-quarters of foreign law bond issuance takes place. Implementation of the new CACs underscores the innovativeness of the contractual framework and once again shows why work on statutory approaches is unlikely to be needed or gain traction in financial policy circles.

6. Conclusion

The recent strengthening of CACs through the clarification of the meaning of the pari passu clause and the advent of single-limb aggregation with strong creditor protections represents a meaningful enhancement of the plumbing of the international financial architecture. More time and work is needed for the new CACs to reach their full potential in enhancing the orderliness and predictability of the sovereign debt-restructuring process. Nevertheless, in a short period of time, the strengthened CACs are already a visible part of the current international financial landscape and have demonstrated anew the vitality of the contractual framework, the foundation for which was established in the early 2000s. US Treasury staff spearheaded and facilitated a highly collaborative international public–private partnership in which all players rolled up their sleeves to ensure success of robust new CACs.

1 The paper refers to many members of the Roundtable. The list is not exhaustive; however, everybody participated with energy and vigour. Treasury staff efforts were supported inter alia by Him Das, Francine Barber and Anne Salladin in the General Counsel’s Office and Brad Setser, Trish Pollard, Sara Senich and Leslie Hull in the International Affairs Department.

2 See Under Secretary for International Affairs John B. Taylor, ‘Sovereign Debt Restructuring: A U.S. Perspective’, at Institute for International Economics, 2 April 2002.

3 Randy Quarles participated in and provided strong support for the Roundtable. His work in the 2002 G10 group provided the Roundtable with the basic insight that specific legal text was essential for the Roundtable to deliver concrete results and achieve success. See BIS, Group of Ten, Report of the G10 Working Group on Contractual Clauses, 26 September 2002.

4 See Randal Quarles, ‘Herding Cats: Collective-Action Clauses in Sovereign Debt—The Genesis of the Project to Change Market Practice in 2001 Through 2003’ (2010) 73 Law Contemp Probl 29–38, < http://scholarship.law.duke.edu/lcp/vol73/iss4/4 > accessed 24 December 2015. Also see Anna Gelpern and Mitu Gulati, ‘Public Symbol in Private Contract: A Case Study’ (2006) 84(7) Washington University Law Rev 1641.

5 See Anne O Krueger, ‘A New Approach to Sovereign Debt Restructuring’ (2002) IMF.

6 See IMF: Annex 1, ‘Strengthening the Contractual Framework to Address Collective Action Problems in Sovereign Debt Restructurings’ (October 2014). Also see Lee Buchheit and Sofia Martos, ‘What to Do about Pari Passu’ (2014) 29(8) BJIBFL 491–93.

7 See Julian Schumacher and others, ‘Sovereign Defaults in Court: The Rise of Creditor Litigation’ (23 June 2013), Santa Clara University. Christian Trebesch participated in the first meeting of the Roundtable.

8 See, IMF (n 6), p 5.

9 The note reflected the input from a number of legal experts participating in the Roundtable, including Anna Gelpern, Law Professor, Georgetown University; Lee Buchheit (Cleary Gottlieb); and Deborah Zandstra (Clifford Chance). Mitu Gulati, Duke University, also provided assistance. Mark Weidemaier, Law Professor at UNC, supported the Roundtable. The content of the note parallels and is discussed in Buchheit and Martos (n 6).

10 See Schumacher and others (n 7).

11 The draft text in particular was the product of the work of legal experts and others in the group. Lee Buchheit, Anna Gelpern, Ben Heller (Hutchin Hill Capital), Brad Setser (Treasury), Deborah Zandstra (Clifford Chance) and Sean Hagan (IMF) were particularly instrumental.

12 Deborah Zandstra of Clifford Chance, London, was the primary drafter of the ICMA clauses with the support of Leland Goss, Managing Director and General Counsel of ICMA, and Robert Gray, HSBC and Chair of ICMA’s Regulatory Policy Committee. See < http://www.icmagroup.org/resources/Sovereign-Debt-Information/ > (accessed 24 December 2015) for a listing of ICMA’s public consultation documents and model language for the UK and New York markets. The Roundtable also benefited from the support of Tim Adams, President and CEO of the Institute of International Finance (IIF); Hung Tran, First Deputy Managing Director of the IIF; and Jean Lemierre of the IIF Board.

13 See, IMF (n 6).

14 The Federal Reserve Bank of New York and the Bank of England provided welcome support for these efforts.

15 See IMF Executive Board Discusses ‘Strengthening the Contractual Framework in Sovereign Debt Restructuring’, Press Release 14/459 (6 October 2014), < https://www.imf.org/external/np/sec/pr/2014/pr14459.htm > accessed 24 December 2015. In particular, a team of legal experts at the IMF steadfastly supported the initiative from the beginning: Sean Hagan, Yan Liu, Nikita Aggarwal, Chanda DeLong and Julianne Ams.

16 G20 leaders also welcomed the progress on CACs at their summit in November 2015 in Antalya, Turkey. This topic will also be part of the Chinese presidency’s G20 agenda in 2016.

17 See IMF, ‘Progress Report on Inclusion of Enhanced Contractual Provisions in International Sovereign Bond Contracts’ (September 2015) < www. imf .org/external/np/pp/…/091715.pdf > accessed 24 December 2015.