A New Approach to Sovereign Debt Restructuring

Anne Krueger

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 2002
• eBook ISBN: 9781589061217

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Core Features of a Sovereign Debt Restructuring Mechanism

What features of a legal framework would need to be in place in order to establish adequate incentives for debtors and creditors to agree upon a prompt, orderly, and predictable restructuring of unsustainable debt? As will be seen, although the features of existing domestic legislative models provide important guidance as to how to address collective action problems among creditors in the insolvency context, the applicability of these models is limited by the unique characteristics of a sovereign state.

Existing Rehabilitation Models and Their Limitations

When a financially distressed—but fundamentally viable—company finds that it can no longer service its debt, the company and its diverse creditors cannot generally turn to their domestic authorities for financing as a means of resolving the crisis. Instead, domestic insolvency legislation provides the necessary framework to overcome coordination problems as they work out restructuring terms. A court-administered reorganization chapter of an insolvency law provides the necessary incentives for a debt restructuring agreement (that often involves substantial debt reduction). To the extent that the insolvency system is well-developed, most restructurings take place “in the shadow” of the law, that is, without the need—and expense—of actually commencing formal court-administered proceedings. As is discussed in Box 1 most well-developed corporate rehabilitation laws include the following features:

• (i) a stay on creditor enforcement during the restructuring negotiations;
• (ii) measures that protect creditor interests during the period of the stay;
• (iii) mechanisms that facilitate the provision of new financing during the proceedings; and
• (iv) a provision that binds all relevant creditors to an agreement that has been accepted by a qualified majority.

All of these features serve to maximize the value of creditor claims by preserving the going concern value of the firm. As will be discussed below, these features are relevant to a discussion of the design of a sovereign debt restructuring mechanism. It should be noted, however, that the applicability of the corporate model to the sovereign context is limited in a number of important respects.

• First, and perhaps most importantly, corporate reorganization provisions operate within the context of the potential liquidation of the debtor, which could not apply to a sovereign state. In the event that a reorganization plan does not attract adequate support from its creditors and the company continues to be in a state of illiquidity, most laws will provide for the automatic liquidation of the company. Moreover, the potential liquidation of the enterprise also limits the terms of any restructuring proposal. Most modern laws provide that creditors cannot be forced to accept terms under a reorganization plan that would result in their receiving less than what they would have received in a liquidation.
• Second, since one of the purposes of a reorganization law is to enable creditors to maximize the value of their claims through the going concern value of the enterprise, most modern laws allow for the creditors to commence proceedings unilaterally so as to acquire the company through a reorganization plan that includes a debt-for-equity conversion that, in some cases, may extinguish all ownership interests of the incumbent shareholders. Again, such a feature could not be applied to a sovereign state.
• Finally, it is difficult to envisage how the constraints that are applied to the activities of a corporate debtor to safeguard the interests of creditors during the proceedings could be made legally binding on a sovereign and enforced, particularly with respect to the exercise of its sovereign powers, including, for example, its fiscal powers. In the sovereign context, we must therefore rely on having the right incentives in place.

Box 1: Corporate Reorganization Model

Although corporate insolvency laws vary among countries, considerable work has been done to identify “best practices” in core areas.¹ The following features of well-developed insolvency laws provide the key incentives for corporate restructuring:

• First, upon commencement of reorganization proceedings, a stay is imposed on all legal actions by creditors, thereby protecting the debtor from dismemberment. This stay is designed not only to protect the debtor, but also addresses the intercreditor collective action problem. In the absence of a stay, creditors would probably rush to enforce their claims out of a fear that others would do so.
• Second, during the proceedings, legal constraints are imposed upon the activities of the debtor and a reorganization plan must normally be prepared within a specified time frame. As a means of ensuring that the interests of creditors are protected during the proceedings, the debtor is precluded from entering into transactions that would prejudice creditors generally (for example, transferring assets to insiders or making payments to favored creditors). To ensure compliance, the laws of some countries also provide for a court-appointed administrator to oversee the activities of the debtor during this period.
• Third, as a means of encouraging new financing, credit provided to the debtor after commencement of the proceeding must be given seniority over prior claims in any reorganization plan. Normally, a creditor that provides financing during the proceedings would have the right to be repaid once the reorganization plan is approved.
• Fourth, a debt restructuring plan approved by the requisite majority of creditors will be binding on all creditors. The law normally provides for the establishment of a committee of creditors that takes the lead in negotiating the terms of the debt restructuring plan with the debtor. To ensure there is no fraud in the voting process, the court normally oversees the verification of creditors’ claims.

A predictable insolvency system enables corporate restructuring to take place out-of-court but “in the shadow” of the formal insolvency system. Such an out-of-court process generally mimics certain features of the formal process. For example, creditors agree to a voluntary standstill in the knowledge that, if they refuse, the debtor can make a standstill mandatory by commencing formal proceedings. Similarly, potential holdout creditors realize that, if they are inflexible, the debtor and majority creditors can use the law to bind them to the terms of the restructuring agreement. In sum, each party negotiates with a clear understanding of the type of leverage it—and the others—would have if the formal system were to be activated.

¹ Including by the IMF, World Bank, and United Nations Commission on International Trade Law (UNCITRAL).

In many respects, Chapter 9 of the United States Bankruptcy Code, which applies to municipalities, is of greater relevance in the sovereign context because it applies to an entity that carries out governmental functions. Although it includes a number of the core features of a corporate reorganization law, it differs from the corporate model in a number of respects. For example, only the municipality (not its creditors) may commence proceedings and propose a reorganization plan. Moreover, the bankruptcy court may not interfere with any of the municipality’s political or governmental powers, property or revenue or the municipality’s use or enjoyment of any income-producing property. Finally, a Chapter 9 case cannot be converted into a liquidation case. All of these features could be appropriately integrated into a sovereign debt restructuring mechanism.

There are, however, important differences between a municipality and a sovereign state that would have implications on the design of any sovereign debt restructuring mechanisms. Unlike a sovereign state, a municipality is not independent. Chapter 9 legislation acknowledges—and does not impair—the power of the state within which the municipality exists to continue to control the exercise of the powers of the municipality, including expenditures. This lack of independence of municipalities is one of the reasons why many countries have not adopted insolvency legislation to address problems of financial distress confronted by local governments.

The Sovereign Context

Although the applic...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Preface
• A New Approach to Sovereign Debt Restructuring
• The Need for a Sovereign Debt Restructuring Mechanism
• Core Features of a Sovereign Debt Restructuring Mechanism
• The Role of the IMF
• The Legal Basis for a Sovereign Debt Restructuring Mechanism
• Conclusion
• Footnotes