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Collective action clauses (CACs) are a new element in the international financial architecture intended to ensure the orderly and timely resolution of sovereign default. Before the Working Group of the Group of Ten (G10) was set up in the summer of 2002, (1) no explicit guidelines or framework existed for the formulation of these clauses. (2) The Working Group's proposed guidelines gained wide currency with their endorsement by the G10 Finance Ministers and Governors in September 2002. (3) At the same time, U.S. private sector trade associations (the Gang of Seven) also developed their own proposals for CACs. (4) The International Monetary Fund (IMF) supported the efforts of both the G10 and the Gang of Seven.
In February 2003, such clauses were included for the first time in a sovereign bond issue under New York law by a large major borrower, Mexico. (5) Several other sovereign borrowers followed suit. By the beginning of 2004, it became clear that key elements of CACs, in particular majority action clauses, were routinely included in this new bond documentation on the New York financial market. This feature is expected to contribute to the more orderly resolution of sovereign debt crises by preventing unwarranted creditor holdouts.
Section I of this Essay provides background on CACs in sovereign bond markets. Sections II and III review recent developments in adopting CACs in sovereign bond issues and the continued international support for adopting these clauses. Section IV provides a preliminary legal assessment of these newly adopted CACs. Finally, Section V reviews some key open issues.
CACs are an integral part of the bond contract between a sovereign borrower and a private sector lender. These clauses become effective if and when a sovereign borrower defaults on a bond. In the international context, a sovereign borrower may default on its bonded debt for a variety of reasons. From a legal perspective, it is easy to claim pacta sunt servanda (contracts have to be honoured), but from a humanitarian, economic, or political perspective, a sovereign state may assess debt payments quite differently. CACs have no influence on whether or not sovereign debt is sustainable. CACs are merely a tool in the restructuring of sovereign bonded debt.
From an international perspective, it is desirable to have a fair, orderly, and timely mechanism for resolving debt restructuring issues. It should be noted that CACs do not affect the substance of the debt negotiation process itself. Rather, they are primarily concerned with the process through which litigation can be settled within the legal system. (6) Thus, though agreement or settlement procedures concluded outside the courts--such as negotiation, mediation, or arbitration--may be satisfactory, they will not necessarily be covered by CACs. (7) Contractual CACs are intended to address two emerging issues: (1) the distribution of a large number of retail bondholders worldwide on the heels of a large credit appetite by some sovereigns, starting with the 1991-1992 boom periods; and (2) the associated issue that some creditors will attempt to manipulate the process for their own benefit. More recently, in-fighting among creditors themselves in order to reach the assets of sovereign states has emerged as a serious threat to orderly and timely restructuring.
Traditionally, CACs were included in sovereign bonds governed by English, Japanese, and Luxembourgian law. Sovereign bonds issued under U.S., German, Italian, or Swiss law did not include such clauses. The largest market for sovereign bonds is in New York State. The adoption of CACs on the New York market was key to providing an internationally acceptable level playing field. (8) While Italy adopted CACs in 2003, under New York law, sovereign bonds issued under German and Swiss law in the last year did not contain CACs.
The role of the official sector is to establish a more transparent and level playing field for debtors and creditors in all major domestic legal systems. (9) Specifically, the goal is to create sovereign debt contracts that reduce legal uncertainty in the international financial architecture. (10) There is also the implicit aim to reduce the time lag between the start of default and final settlement. (11) CACs allow the official sector to become a facilitator of change for the benefit of debtors and creditors. Financial intermediaries may benefit as well because private sector participants would not be able to provide unbiased input to this process easily.
For the most part, the markets have paid little attention to the inclusion of CACs. One is thus inclined to conclude--at least at this point in time--that business concerns over CACs will vanish and that CACs will be a non-factor in bond pricing of new sovereign issues.
However, there is no evidence thus far about how CACs might perform in a case where a major sovereign bondholder defaults on bonds that include CACs. There may also be a realization by markets that sovereign bonds without CACs should have mark-up costs because litigation in default may be longer, more drawn out, and subject to higher legal risks than for bonds without such clauses. (12) Also, since the initial public recognition by the Emerging Market Credit Association (EMCA) of Mexico's first bond issue with CACs in February 2003, the Gang of Seven has remained silent on the type of CACs that countries have chosen to employ.
II. THE ADOPTION OF CACs IN SOVEREIGN BOND ISSUES IN 2003-2004
The year 2003 may be dubbed the watershed year for CACs. For the first time, they were widely adopted by a range of key sovereign issuers in New York. (18) The official sector continued to play an active role. The European Union (EU) officially recommended including CACs in sovereign bond issues by European borrowers. The IMF and World Bank included a recommendation for the addition of CACs in their revised Amendments to the Guidelines for Public Debt in November 2003. (19) Furthermore, towards the end of 2003, the G10 continued its leading role by setting up an informal review mechanism to assess the adoption of CACs.
The breakthrough in terms of actually introducing CACs in sovereign bond issues on the New York market occurred with the Mexican bond issue of February 2003. Other countries followed suit--specifically Uruguay and Brazil in April, Korea and South Africa in May, Belize in June, Italy in July, and Turkey in September. In 2004, Chile, Hungary, Panama, Colombia, Costa Rica, the Philippines, and Venezuela successfully completed bond issues including CACs for the first time, while Brazil, Turkey, and Mexico's 2004 issues again included CACs. (20) Some sovereign states did not include CACs in their 2003 New York issues, such as China and the Philippines. (21) While there were no sovereign bonds with CACs on the New York market in 2002, in 2003 nearly 50% (on a value basis) of all new sovereign bonds under New York law included CACs (see Table 2).
In 2003, there were no CACs included in the sovereign bond issues on the German and Swiss markets. The basic documentation of the only sovereign bond issue by Turkey on the German market and also the only sovereign bond issue by Greece on the Swiss market remained virtually unchanged. (22) The Japanese and U.K. sovereign bonds all included CACs. (23) Thus, close to 60% of the sovereign bonds issued worldwide in 2003 (on a value basis) contained CACs. (24)
III. CONTINUED INTERNATIONAL SUPPORT FOR THE INCLUSION OF CACs IN 2003-2004
The support of the Finance Ministers of the EU countries was a key element in promoting inclusion of CACs. In his speech to the International Monetary and Financial Committee (IMFC) in April 2003, Greek Minister of Economy and Finance Nikos Christodoulakis, acting in his capacity as President of the EU's Economic and Financial Council (ECOFIN), announced that
the EU will use contractual provisions [CACs] based on the framework developed by the G10, and where necessary in accordance with applicable law and adjusted to local practice, in their central government bonds issued under a foreign jurisdiction and/or governed by a foreign law by the end of this year. (25)
Italy subsequently introduced CACs in the documentation of all New York law governed bonds issued after June 16, 2003. (26)
The IMF continued its supportive role in 2003, as reflected in the April 2003 Communique of the IMFC. The Guidelines for Public Debt Management now explicitly state: "When issuing sovereign bonds governed by foreign laws, debt managers should consider including these clauses in new borrowings, in consultation with their financial and legal advisors." (27) Other publications, like the IMF Survey, also continue to support the adoption of CACs, and the IMF has started to encourage the use of such clauses in the context of its annual country and multilateral surveillance efforts. (28)
Towards the end of 2003, the G10 recommended taking stock of developments and continued to monitor changes and emerging problems carefully. The G10 plans to examine the CACs included in sovereign bonds in their recent bond issues and to assess any differences vis-a-vis the G10 template. (29) The follow-up process will take place during 2004. Similarly, in a press release during early 2004, the U.S. Treasury had shown a renewed commitment to include CACs in sovereign bonds under New York law. (30) The Gang of Seven continued to voice support for CACs in their Florida communique in February 2004. (31)
IV. SELECTED KEY ISSUES IN THE INTRODUCTION OF CACs
International institutions continue to monitor closely the role of CACs in sovereign bonds. …