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Lawyers for whom the debt crisis of the early 1980s created an interesting intellectual challenge how do you deal with a borrower which can go bust but can't be wound up? have seen it turn into their life's work. Mexico's peso devaluation of late 1994 reminded them, if reminder were needed, that demand for their expertise should outlast their careers. The problem is that the legal solutions devised in the 1980s are themselves already outdated.
S The reason for this is that much of the sovereign debt raised in the 1990s has come from the bond market, a market with a diversity of holders not matched by the comparatively collegial commercial banking market which provided the original loans rescheduled during the 1980s. Indeed, much of that earlier commercial bank lending was securitized into Brady bonds as part of the rescheduling process and sold off to non-bank investors. As that debt has become tradeable on the secondary market, so the spectre of the maverick creditor has increased.
The maverick creditor originally sprang from the unanimity requirement included in the very first rescheduling agreements. "This principle was enshrined in clauses of rescheduling agreements dealing with amendments to the contracts," explains Lee Buchheit, a partner in law firm Cleary Gottlieb Steen & Hamilton. "Except in rare circumstances, those clauses expressly required the unanimous consent of all lenders before any term of the agreement dealing with the amount or the timing of payments could be changed. The proponents of these clauses argued that they were necessary to assuage the concerns of the smaller lenders about joining restructuring syndicates in which larger, money-centre banks held a predominant position. In retrospect, it was a mistake for the larger banks to concede this degree of leverage to their smaller colleagues through the unanimity requirement."
What happened was that some smaller banks could hold up entire rescheduling processes in an effort to be bought out on the side at preferential terms. The unanimity requirement was effectively circumvented in 1987 when Mexico and the Philippines, and subsequently other countries, signed restructuring agreements containing debt-for-debt exchange provisions. These clauses allowed debts to be lifted out of restructuring agreements and exchanged for new debt instruments.
Creditors that were not prepared to accept the exchange offer remained bound by the original restructuring agreement and could not share in any payments made under the new debt instrument. This meant that the payment terms of restructuring agreements could, in effect, be amended in favour of those creditors opting for the exchange without having to obtain the consent of every other creditor party to the original restructuring agreement. This paved the way for the legal mechanisms that implemented the Brady initiative.
A few creditors, however, welcomed the prospect of being left behind in the old restructuring agreements because they saw this as an opportunity to force by negotiation or litigation a settlement of their claims on preferential terms. Because sovereign borrowers do not come within the rule of domestic insolvency regimes they have no protection against individual creditor actions, no matter how many other creditors are prepared to accept a rescheduling package. "For reputational reasons, well-established banks and financial institutions rarely play the role of the maverick, particularly the litigating maverick," explains Buchheit. "Most mavericks are obscure, special-purpose entities organized in obscure, under-regulated jurisdictions" this is because many sovereign loan and debt-restructuring agreements permit assignments of interests in loans to "banks or financial institutions" only.
Imagine the reaction of the majority of creditors who had accepted a reduction in the principal or interest due on their own loans. "As seen by his fellow lenders, the maverick is simply capitalizing on their willingness to grant the borrower a degree of debt relief," says Buchheit. "It is only by virtue of the indulgence shown by the majority of creditors that the sovereign has the money to pay or settle on preferential terms the claims of the more exacting few. This resentment can be aggravated where the maverick bought his claim on the secondary market at a small fraction of its face value, while the original lenders advanced 100 cents on the dollar. It is like giving up your seat on a crowded bus to an elderly woman only to watch a teenager jump on it."
Majority creditors sometimes insist that any special deals be made available to everyone. "In some recent Brady-style reschedulings under English law the sovereign borrower has been asked to covenant that it will not enter into any arrangement with a non-participating creditor" a maverick "on terms more favourable than those offered in the Brady deal without those preferential terms being offered to the rest," says Buchheit.
But mavericks are not the only reason why legal mechanisms underlying the restructuring process are being rethought. "Nearly everyone involved in the rescheduling process in the early 1980s tried to promote the idea that the external debt problems of the affected countries could be resolved quickly," says Buchheit. "Debtors saw their salvation in a speedy return to normal borrowing practices, and a frank assessment of their medium-term debt-servicing capacity would probably not have contributed to an early achievement of that objective." Banks, for their part, were not prepared to admit that they would not be repaid anytime soon: their capital ratios were thin and their loan-loss provisions small.
The effect was the opposite. The debt reschedulings dragged on for a decade because at least until the Brady initiative they never provided anything more than temporary debt relief to the sovereign borrowers. The result was that access to the capital markets was blocked throughout the 1980s. The realization that market access must be maintained is what prompted the rapid us-backed rescue package for Mexico, a $20 billion bail-out, of which $12.5 billion was eventually borrowed. Few believe such a package would be repeated for other hapless borrowers, even though its success is borne out by Mexico's subsequent successful refinancing through the voluntary capital markets. It was the speed of the rescue that ensured its success.
These lessons have not been lost on lawyers. Proposals to accelerate future sovereign debt restructurings include adopting an international bankruptcy code (which sovereign borrowers could invoke to stay all creditor actions while a refinancing is put in place) adding contractual clauses that would allow majority creditors to modify payment terms without unanimity, designing a framework for bondholder committees to represent bearer bondholders, giving sovereign borrowers legal defences in national courts against maverick creditor actions and establishing an international tribunal to resolve sovereign debt disputes.
It's no coincidence that all the measures would shut out maverick creditors.
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