Sovereign Debt Restructuring
• Overview
• Paris
Club
• London Club (BAC)
• The Role of the IMF in a BAC.
• The Role of Advisors in a BAC
• Why Debtors Need Good Advice on a Timely basis
• Summary
This note is intended to clarify the roles of the World Bank, the IMF and private sector advisors in Sovereign debt restructurings. To do so, a brief overview of the two types of debt restructuring machinery that are employed in Sovereign restructurings will be presented: The Paris Club and the London Club (or the Bank Advisory Committee “BAC”) and then the roles of the various parties is briefly discussed along with the question of how third party restructuring advisors are normally retained.
You will note that private outside advisors (similar to Recovery Partners) have been an integral feature of both pieces of debt restructuring machinery. You will also note that the role of the IMF has been very tightly defined, and that the role of the World Bank and other donor organizations in both processes has been non-existent or limited.
Overview
The terms Paris Club and London Club are sometimes misleading because there is no “Club” per se. These terms more accurately refer to processes for dealing with sovereign liquidity, solvency and debt default problems.
The Paris Club has involved 364 operations between 1956 and 2002 involving seventy eight countries. The most comprehensive inventory of London Club (commercial restructuring) deals are found in reports issued by the Institute of International Finance (IIF). The latest IIF survey lists 260 London Club deals between 1979 and 2000 involving sixty two countries.
Paris Club
The Paris Club grew out of a series of negotiations with countries experiencing balance of payments problems in the 1950’s and 1960’s for the narrow purpose of restructuring debt owed to bilateral donor agencies. Its principles and procedures were codified at the end of the 1970’s in the context of the North-South dialogue. The number of Paris Club negotiations grew exponentially in the 1980’s and they were generally completed quickly and smoothly.
Until 2001 the Paris Cub was one of the most mysterious non-transparent pieces of machinery in the international financial system. Just around the same time, a sea change took pace in the IMF and the World Bank and other international institutions. As
they became more transparent, the Paris Club’s secrecy became less defensible. Thus we can now discuss with some certainty the main principles that drive activity within this framework:
Case-by-case approach which recognizes individual circumstances.
Decisions based on consensus of member countries
Conditionality based on the implementation of an appropriate program supported by the IMF which demonstrates the need for debt relief
Solidarity of creditors who agree to implement the terms agreed in the context of the Paris Club
Comparability of treatment of countries seeking relief
The Paris Club has competed over 360 separate negotiations involving notional debt amounts well in excess of USD400 Bn since its inception. Through this experience a well defined process has emerged that has three elements: triggering actions and preparations, the analytical framework of the IMF; and a negotiating session.
Triggering Actions: A debtor country must submit a request to re-negotiate its debt. This request may be based on a variety of factor, economic shocks, natural disasters, political upheaval etc. Most countries in this position have historically sought outside advice. Experienced debt restructuring advisors and lawyers have thus been typically hired to help with the negotiations.
The IMF Framework: The first step in curing a default is for the debtor country to change the behavior of the pubic and private sector entities that contributed to the debt crisis in order to restore creditworthiness. In this context the IMF’s balance of payments projections provide a quantitative framework for the restructuring of negotiating terms.
The Negotiating Session: Since 1983 the Paris Cub has reserved one day a week in every month except for February and August for its business. The debtor country delegation is usually composed of the Minister of Finance, senior government officials, and the country’s debt restructuring advisors and lawyers. Creditor countries and observers (UNCTAD, IMF/IBRD) are also present. The process is well scripted and usually a deal is reached fairly quickly.
The Paris Club machinery for restructuring debt owed to bilateral donor agencies has functioned well, but with mixed results. By the late 1980’s it had exhausted the flexibility available within the boundaries of debt rescheduling in responding to the chronic debt problems of a substantial group of low-income countries. Another problem surfaced in the 1990’s. The Paris Cub was adamantly opposed to granting debt reduction or to consider forms of debt relief common in commercial workouts. This made little sense.
Much of the current controversy about the Paris Club results from the sea change in emerging markets finance that took place during the 1990’s. The dominance of private capital flows is expected to continue indefinitely which means that workouts in the future are increasingly likely to involve countries that are far more dependent on private capital flows that on official flows. As a consequence, workout machinery is now required that is sensitive to the commercial factors enabling countries to regain access to private capital after a crisis. This is yet another area where recourse to, and use of, experienced financial advisers, has proven to be, and will continue to be, of significant benefit to debtor countries.
London Club
The origins of the London Club label are obscure. The BAC process emerged out of commercial bank negotiations with a handful of debt-distressed countries. Existing practices for corporate workouts, the Paris Club, and pre-war experience with bond workouts all contributed to the eventual design.
The architects of the BAC process were the banks and advisors assisting them and the debtor countries, not the IMF or any other public sector body. The design drew heavily on commercial experience with corporate workouts. Unlike the corporate process however, the BAC process involved close collaboration and/or coordination with public sector institutions such as the IMF and Paris Cub, reflecting the political factors inherent in sovereign workouts.
No machinery of any kind existed before 1975 for multi-bank reorganization of commercial debt. The process was refined and over the next eight years and more than one hundred restructurings were completed before the concept of debt reduction was introduced under the Brady Plan at the end of the 1980’s debt crisis.
However it was significant that two groups of creditors were not represented on the BACs before 1995: Bond investors and suppliers. The treatment of bonds became a central issue in the Mexican Peso Crisis of 1994 and more generally because bond flows to developing countries had began to outstrip the flows of commercial lending. As bondholder representation on the BACs grew, BACs were being relabeled more commonly as “Creditor Committees” and akin to what one would find in a company restructuring under a national bankruptcy regime. These developments caused several commentators to declare the London Cub dead at various points in the 1990’s.
Long-term borrowing from commercial banks grew very rapidly during the 1970’s in response to financial innovation (syndicated loans) and commodity price developments (oil shocks and the need to re-cycle petrodollars). In short order debt servicing problems began to crop up in the developing countries.
Sovereign workouts cannot be carried out under the bankruptcy insolvency laws used for corporate workouts. No international law, convention or treaty governs how default by a sovereign borrower will be resolved. However the BAC or London Club machinery has resolved over 260 restructurings with commercial banks since 1980. The actual machinery evolved out of commercial bank experience with borrowers of all kinds. It was not imposed on banks by the IMF or G-7.
The main principles of the BAC are: case-by-case restructuring; voluntary restructuring and market-based restructuring.
Case-by-case: this remains the starting point for al creditors in debt workouts with sovereign borrowers as each workout must be custom tailored to each country-specific situation;
Voluntary Restructuring: in this context means that the terms of a restructuring are negotiated between the banks and the debtor country until a mutually agreeable outcome is reached. The opposite of a voluntary restructuring is a workout that is forced
on the debtor country by the IMF or Word Bank or as a result of a take it or leave it offer by the debtor country.
Market-based Restructuring. There are three elements to this concept – it is flexible, pragmatic and apolitical to the extent possible. Flexibility allows the parties to craft solutions across a wide range of possibilities so that the many parties to these negotiations can find a solution that suits. In corporate workouts the treatment of different cases of creditors is a key issue. The differential treatment relates to both historical practices as well as to legal rights and obligations. In the sovereign arena this could be seen as the more favorable treatment of trade and inter-bank creditors. In the arena of sovereign workouts it is impossible to set aside political factors
The actors in a BAC typically feature banks, the IMF, specialist debt restructuring companies and advisors and lawyers and accountants: On the Creditor side of the table are the bankers, their advisors and their lawyers. On the Debtor side of the table are usually the Minister of Finance, Senior Finance and Central Bank officials and their commercial debt management advisors, lawyers and accountants. The IMF has in the past sat in the middle of these meetings, if invited, and has advised the various parties.
The Role of the IMF in a BAC.
The IMF Mission Chief may be invited to participate in preparatory meetings to describe the expected IMF support for the country and to answer any questions BAC members had about the assumptions used to drive the IMF’s Balance of Payments projections. However, unlike the Paris Club, the BAC members do not have to take the IMF projections as gospel. BAC subcommittees do their own analysis but usually with significant input and assistance from the IMF. In addition the IMF has typically also had the following input into the BAC process: (1) during the rescheduling negotiations the IMF team is often invited to the sessions to answer technical questions; (2) depending on the circumstances the IMF has been known to exert pressure on one or more parties to modify their negotiating stance; (3) in the closing stages of many BACs in the 1980’s the IMF would typically issue a comfort letter that provided assurances to the BAC that the country’s recovery program would lead to a viable Balance of Payments position, that the IMF would monitor the progress made under the program; and that the IMF would keep the banks informed about the results.
The Role of Advisors in a BAC
In the late 1970’s and 1980’s the heyday of commercial bank loan restructurings many investment boutiques were set up to specifically cater to market demand for loan restructuring advisory services. Some of these firms would only take on Debtor Representation assignments; others would specialize in Creditor Representation; while still others would seek both Creditor and Debtor Representation assignments. These boutique advisory services included names such as Shearson’s, Barings, Warburgs and Bankers Trust. Since those days many of these businesses have been shut down or have morphed into distressed debt trading and sub-investment grade asset management and advisory companies similar to Recovery Partners. However, in all of these situations the services of knowledgeable and experienced independent third parties are sought for in restructurings, and particularly for the more complex cases
Advisors are typically hired on the spot as are lawyers, auditors and other niche professionals. They are typically firms that are familiar with the key elements of the situation and personalities involved. They are also firms that through connections and experience are able to rapidly deploy the requisite skill sets to commence a remediation without any undue delay and in a professional and risk minimizing way. Thus the advisors chosen are typically the advisors with the most experience with similar situations and the ability to respond to the typically urgent need for assistance in the early stages of a crisis enabling a general default and/or more significant loss of value to be avoided.
Here are a few additional observations on the process:
The key objective in any commercial restructuring is to preserve asset values both for the benefit of the creditors and the debtor(s). This is a legal obligation of the restructuring advisors. They must typically be third parties to the situation and not legally or economically connected to the debtor or creditors save for the advisory contract governing their activities in the restructuring.
The bankrupt company (or Sovereign) cannot lead any restructuring or advise itself because the management, board of directors and shareholders (or controlling authority) are conflicted in their goals (with the creditors) as they are aiming to minimize their legal liability or in certain cases may be motivated by political considerations which can give rise to perverse outcomes. In the case of a Sovereign bankrupt or failed SOE, the Government most typically would want to maximize the value of tax receipts or other income it may be in position to reap from the bankrupt SOE. Their role as advisors to the restructuring is consequently not legally acceptable or enforceable. In a restructuring situation advising oneself is most typically illegal in developed country jurisdictions precisely because it sets the interests of the bankrupt squarely against the interests of employees, and the secured and unsecured creditors and others that could be potentially impacted by the outcome of the process.
For the same reason any one creditor in a group of creditors that has lent to a now bankrupt Sovereign or Sovereign-guaranteed SOE cannot advise the bankrupt because it will be conflicted by its inter-creditor position with the other lenders.
From a legal standpoint, therefore no party in the waterfall of debts that are affected directly by the Sovereign or Sovereign-guaranteed SOE bankruptcy or that are a party to other debt agreements that may be outside the immediate ambit of the debt restructuring may legally advise on the restructuring of any Sovereign or Sovereign-guaranteed debt in the typical situation. This includes multilateral organizations.
Why Debtors Need Good Advice on a Timely basis
Restructuring advisors in a commercial setting are typically hired on the spot because of the urgency of the situation and the need to preserve value. All advisors have typically been hired on an expeditious basis for restructuring mandates for the following key considerations:
• Asset values must be preserved and therefore time is of the essence. If work does not commence immediately, significant value will be lost through dissipation
(loss, theft or other value deterioration) of the collateral assets that may exist to secure the debt. An advisor will typically seek to control, assess, value and inventory all collateral assets immediately to minimize this risk. From a Sovereign perspective, failure to act quickly could result in a solvency crisis, significant output loss, destruction of domestic real asset values and savings, and social disorder and reduced debt servicing capacity. Failing to act quickly maximizes the risk of value loss relating to a variety of factors.
• Loss of Negotiating Position and Signaling. A typical response to most situations requiring restructuring is denial by the Government, the management or other controlling authority. As time elapses and situation becomes more dire, lenders will typically not retreat from negotiating positions that will have hardened by the debtor’s failure to deal with the repayment problems on a timely basis. This will cause the borrowing costs and other terms of the restructured borrowing to be less favorable than if the problem were dealt with proactively. Failure to get GOOD ADVICE quickly increases this risk significantly not only because it lengthens the time needed to get the restructuring going it also signals to the lenders and their advisors that the borrower may be indifferent to unfavorable and costly borrowing terms.
• Problem Misidentification. The individuals within the Government or beleaguered organization who are charged with developing a response to the crisis need to develop ideas that specify the situation and the remedial activities upon which a restructuring must be based. Typically these individuals are seeing the crisis for the first time and may also have personal attachments and loyalties involved. If the problem is misidentified, then the exercise will result in a failed restructuring because some needed remedial steps will be left undone. Leaving the problem specification to individuals that are unfamiliar with the restructuring process and the behavior of multilateral institutions enormously magnifies the problem identification risk relative to contracting experienced advisors with a mandate to determine what must be done.
• Contagion Risk. In situations where the entity is a Government guaranteed SOE or Bank there is a risk that contagion may spread to other institutions or the economy as a whole. What started out a manageable liquidity problem may blossom into a full-scale solvency crisis if matters are not dealt with promptly and professionally. Failure to act quickly with experienced advice increases the risk of a solvency crisis when there are vital financial connections between the bankrupt SOE , domestic financial institutions and the Government.
A review of the materials available through the IIF or referral to the publications in the bibliography attached will confirm the above observations
Summary
In Paris Club restructurings:
• The IMF has advised the multilateral agencies
• Private Debt Restructuring Advisors play a central role in advising Governments. In London Club (BAC) Restructurings:
• The IMF has a potential role as source of information and oversight
• The World Bank has never had any formal role
• Private Debt Restructuring Advisors play the central role in motivating action, organizing resources and achieving results.
Recovery Partners March, 2010
Bibliography
The following sources and references will confirm the information and facts as presented above:
1. Restructuring Modern Debt: The Case for AD HOC Machinery By Lex Rieffel
2. Birdsall, Nancy, and John Williamson. 2002. Delivering on Debt Relief: From IMF Gold to a New Architecture. Washington: Center for Global Development and Institute for International Economics.
3. Boot, Anthony, and Kamau Thugge. 1997. “Debt Relief for Low-Income Countries and the HIPC Initiative.” Working Paper 97/24. International Monetary Fund, Washington (March).
4. Boughton, James M. 2001. Silent Revolution: The International Monetary Fund, 1979 – 1989. Washington: International Monetary Fund.
5. Brau, E., and others. 1983. “Recent Multilateral Debt Restructuring with Official and Bank Creditors.” Occasional Paper 25. International Monetary Fund, Washington.
6. Camdessus, Michel. 1984. “Governmental Creditors and the Role of the Paris Club.” In Default and Rescheduling Corporate and Sovereign Borrowers, edited by David Suratgar. London: Euromoney Publications.
7. Clark, Keith, and Martin Hughs. 1984. “Approaches to the Restructuring of Sovereign Debt.” In Sovereign Lending: Managing Legal Risk, edited by Micheal Gruson and Ralph Reisner. London: Euromoney Publications.
8. Dammers, Clifford. 1984. “A Brief History of Sovereign Defaults and Rescheduling.” In Default and Rescheduling Corporate and Sovereign Borrowers, edited by David Suratgar. London: Euromoney Publications.
9. Eichengreen, Barry, and Richard Portes. 1989. “After the Deluge: Default, Negotiation and Readjustment during the Inter-War Years.” In The International Debt Crisis in Historical Perspective, edited by Barry Eichengreen and Peter H. Lindert. MIT Press.
10. Institute for International Finance. 2001. Survey of Debt Restructuring by Private Creditors. Washington (April).
11. Institute for International Finance. 2003b. “Crisis Resolution in the Context of Sovereign Debt Restructuring: A Summery of Considerations.” Washington (January 28). www.imf.org/external/np/pdr/sdrm/2003.012803.htm (April 5, 2003)
12. Rogoff, Kenneth and Jeromin Zettlemeyer. 2002. “Bankruptcy Procedures for Sovereigns: A History of Ideas, 1976 – 2001.” IMF Staff Papers 49 (September): 470 – 507.
14. http://www.clubdeparis.org/
15. http://en.wikipedia.org/wiki/London_Club
16. http://www.iif.com/
17. http://www.imf.org/
