Two-step sovereign debt restructuring: a market-based approach in a world without international bankruptcy law.

I. PREFACE

Our paper was originally circulated in April 2002, just a few months after the International Monetary Fund's (IMF) November 2001 Sovereign Debt Restructuring Mechanism (SDRM) proposal and Argentina's December 2001 default on its external debt. At that time, little progress had been made in persuading sovereign issuers to include Collective Action Clauses (CACs) in international bond documents governed by New York law, and neither sovereign issuers nor investors seemed eager to see such clauses. Since then, there have been several important developments.

Following a hostile market reception to its initial SDRM proposal, the IMF modified it, reducing somewhat the role the IMF itself would assume and putting more power in the hands of bondholders. (1) But investors remained opposed to what they saw as an attempt by the official sector to reduce their already weak enforcement rights with respect to sovereign debt. And sovereign issuers remained opposed to what they feared would raise debt costs and perhaps reduce market access. By contrast, in the official sector, SDRM was viewed as a sensible way of dealing with collective action problems in debt restructuring, facilitating a quicker resolution of sovereign defaults to the benefit of both investor and issuer. It was finally presented at the April 2003 meeting of the International Monetary and Financial Committee (IMFC). While support was very high (reportedly more than 70%), it fell short of the 85% required to begin implementation by amending the IMF's Articles of Agreement. (2)

While SDRM did not garner the required support, the proposal was a major factor in getting the market to accept CACs. During 2002, investors began to view CACs more favorably, in preference to the SDRM alternative. And in February 2003, just a few weeks before the IMFC meeting, Mexico came to the market with a new bond that included CACs. Because Mexico has a very well defined yield curve, it was relatively straightforward to determine whether or not there was a spread premium associated with CACs. There was not, and this settled one of the main reservations issuers had with CACs. Since Mexico's adoption of CACs, virtually all new sovereign issuance has included the clauses, and the language has followed very closely what has become known as the "Mexico Standard."

In addition to the sidelining of SDRM and the acceptance of CACs, another important development since this Paper was originally circulated was the Uruguay debt restructuring. Uruguay, an investment-grade country prior to the Argentine default, suffered a major devaluation and suddenly found itself facing a liquidity crisis. Unable to refinance its maturing bonds, it proposed an innovative preemptive debt exchange, employing some of the mechanisms discussed in our "Two-Step" paper. With the exception of one yen-denominated issue governed by Japanese law, all of Uruguay's international debt was without CACs. Uruguay asked investors to exchange their existing bonds for new bonds with longer maturities, but with no reduction in face value or coupon rate. Bondholders were also offered the option to consolidate into one of three benchmark issues. Because it was not clear whether or not a simple maturity extension would be sufficient, Uruguay also included in the new debt CACs with a limited form of aggregated voting, which would make coordination among bonds easier if a second, more severe restructuring were needed. By concentrating the debt into fewer but larger instruments with aggregated CACs and without reduction in legal claim, the Uruguay exchange was somewhat like the first of our proposed two steps, with the second step only happening if needed.

One premise of our "Two-Step" proposal was that a legal framework for dealing with sovereign debt restructurings (something like SDRM) did not exist, might not be desirable, and in any case was likely to generate significant political opposition, making early enactment unlikely. Another premise was that even if CACs became standard in new issuance, as they indeed have become, it would take some time for the entire stock of outstanding sovereign debt to be converted. In addition, with the exception of Uruguay, CACs as implemented do not contain aggregation provisions across instruments, so coordination across many bonds could still pose a significant challenge. JPMorgan's "Two-Step" proposal demonstrated that, even with these difficulties, it was possible to conceive of market mechanisms that could deal efficiently and effectively with even very complex sovereign debt restructurings.

II. INTRODUCTION

While a good deal of progress has been made in the last few years on defining measures to help prevent financial crises, much less has been made on creating procedures …