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Capital Markets

Bondholders won't back new principles

Top bankers' talking shop the Institute of International Finance and the G-20 group of sovereign borrowers have proudly unveiled a new set of principles for orderly restructuring of sovereign debt. The Argentina fiasco underscores the urgent need for such an agreement. Unfortunately, this one was negotiated without much input from the most important groups of creditors.

The kind of private-sector
representative the official
sector likes to deal with

THE PRESS CONFERENCE at the Institute of International Finance (IIF) at the end of last month was a grand affair. The great and the good present included Jacques de Larosière, former head of the Banque de France, the IMF and the European Bank for Reconstruction and Development. "You are attending a meeting which is to some extent historical," he told journalists. "Issuing countries and the private sector have gotten together and have agreed on a set of principles: this in itself is a great achievement." He waxed almost poetical. "We have tried to bring out the quintessence of what is good and what is rational," he said. The chaos of Argentina's attempt to resolve its default has highlighted again the worrying absence of agreed procedures for sovereign debt workouts. So, on the surface, such an agreement appears welcome.

De Larosière was followed by HSBC's Robert Gray, chairman of the International Primary Market Association (Ipma), who also lauded the principles. "These are a very important step forward in making the process of debt restructuring more orderly and more predictable," he said.

Issuers were also well represented. "If we had devised this instrument a few years ago, some of the problems we have observed over the past few years would have been considerably attenuated, and some would not have occurred," said Alexandre Schwartsman, deputy governor for international affairs at the Brazilian central bank.

Overseeing the meeting was Charles Dallara, managing director of the IIF and chief architect of the document that had been formally welcomed by the G-20 developed nations and sovereign borrowers only the day before. The principles, he said, were "a potentially important addition to the architecture" supported not only by the G-20 but by a wide range of investors. "We are pleased by the breadth of private financial sector support for these principles," he said, citing the IIF's 345 members, as well as Ipma endorsement.

Discontent in the ranks

The IIF certainly has a lot of members – banks and investors – although the extent of the rank and file's enthusiasm for the principles in question remains in doubt.

Ipma represents debt underwriters, and has a vested interest in remaining on good terms with the largest sovereign issuers. Other private-sector organizations were conspicuous by their absence. Not a single bondholder spoke. Although buy-side organizations such as Pimco are IIF members, and Pimco's chief emerging-market fund manager, Mohamed El-Erian, is even on the IIF's lists of individuals involved in drafting the principles, Euromoney has spoken to a large number of bondholders, all of whom either actively opposed the principles, refused to endorse them, or were too busy to pay much attention to what was going on. El-Erian falls into this last category.

Dallara and de Larosière might trumpet unprecedented collaboration between the private and official sectors, but most of the emerging-market foot soldiers, at least in the private sector, have grave misgivings about the principles in their final form.

The debtor nations in the G-20 were certainly happy with the IIF's "Principles for Stable Capital Flows and Fair Debt Restructuring in Emerging Markets". Brazil, Korea, Mexico and Turkey, having ensured that virtually everything creditors wanted in such a document was excised, have been happy to officially endorse them.

What remains, though, is deeply worrying to many market participants. The principles might have been pushed through by the IIF, a private-sector organization, but in the process the IIF was less of a market animal than a creature of the official sector.

The driving forces behind the principles were Jean-Claude Trichet, then head of the Banque de France; de Larosière; and the first person the official sector turns to when it seeks private-sector coordination, Citigroup's Bill Rhodes.

After the 2002 G-20 meeting in New Delhi, these three, concerned that the IMF's proposed sovereign debt restructuring mechanism (SDRM) could devastate emerging-market finance, tapped Dallara to devise a private-sector alternative.

During the IIF press conference, Alonso García Tames, director of public credit at the Mexican finance ministry, referred to de Larosière as a "private-sector representative". That is a revealing insight into the kind of private-sector representative the official sector likes to deal with. De Larosière spent almost his whole career at the top of the official sector, and represents the private sector now only in his role as an adviser to the chairman of BNP Paribas.

One persistent criticism of the process behind the principles is that people with first-hand market experience, especially traders, lawyers, bondholders and other private-sector trade bodies, were left out when they deviated from the IIF path. Dallara, especially, is often accused of being the type of bureaucrat who operates by getting the most important people on board, then using them to quash opposition lower down their own organizations.

Dallara has an answer to this. "We have worked on this at all levels," he says, adding that "this is not about revisiting process, it's about going forward together: my impression is that even those with remaining concerns do broadly support the thrust of the principles".

An answer to SDRM

The process began as a reaction to the IMF and its attempts to implement SDRM. "The SDRM did not convince the private sector or the issuers," recalls de Larosière. "We were expected to try a more market-based, voluntary approach."

Shortly after Dallara's exercise started at the beginning of 2003, however, Mexico inserted collective action clauses (CACs), into its bond documentation, and the US Treasury sent strong signals that SDRM was effectively dead. If the IIF project was designed as an SDRM killer, its main purpose had now become moot.

The CACs didn't solve anywhere near the same problems that SDRM addressed, however. "CACs are a very narrow solution to a very narrow problem," says Mark Siegel, emerging market fund manager at DL Babson in Washington. "They should be put in the context of some sort of acknowledgement, if not promise, by debtors and multilaterals that there would be an understanding about engagement" – the process by which debtors and creditors arrive at an understanding on any debt restructuring that they might agree is necessary.

Before Mexico went ahead with its own CACs, a group of private-sector trade organizations, including the IIF – the "gang of seven" – released their own model CACs. These included engagement clauses – something Mexico left out, but which three recent issuers – Hungary Latvia and the Slovak Republic – have decided to include.

"CACs were a one-way transfer of value from bondholders to sovereigns," says an emerging-market investor. "What we were hoping for in return was some agreement about the definition of good behaviour."

What investors – and, at the time, Trichet – wanted was a detailed code spelling out exactly what issuers and investors were expected to do if there was a solvency or liquidity crisis. To that end, the gang of seven's model CACs had a 10-page code of conduct attached. But without SDRM hanging over their heads, issuers, especially, were in no mood to commit themselves to any such document.

This was, more or less, the code that Dallara first presented at a special meeting in Paris in the summer of 2003, convened by Trichet and designed to bring issuers, investors, intermediaries and other interested parties together.

There were a couple of changes from the code that the gang of seven had signed off on a few months previously. Most notably, Dallara pushed the idea that a semi-permanent monitoring group should serve as a forum for early consultations between an indebted sovereign and its private-sector creditors. Dallara dubbed this a private sector advisory group, which could initiate meetings with creditors if it was worried about the direction they were moving in.

No lectures, please

The idea of a group of private-sector "wise men" calling in a troubled government to intone about fiscal responsibility and the like did not go down well with the sovereign borrowers, principally Mexico and Brazil. "We expressed our opposition to that idea," says Mexico's García, and by the time the meetings had ended, it was clear that if the code were to have any future, Dallara would have to start all over again.

The code of conduct, as it existed in the summer of 2003, did at least include all of the main things that emerging-market creditors had been asking for. It brought up exit consents, saying that sovereign debtors should "avoid any coercion of creditors by impairing existing bond and loan provisions". Exit consents are commonly used in bond exchanges to encourage participation; they can, in theory, be very coercive.

The code also said that when dealing with a creditor group, "the reasonable costs of such creditor group's financial and legal advisers should be borne by the sovereign debtor". And it had words for the IMF. The Fund, it said, should "vigorously support all efforts to avoid default and a comprehensive restructuring, including informal approaches to regaining market stability".

That language was inserted with the memory of Ecuador, in particular, fresh in the market's mind: it is generally assumed by investors that the IMF exerted pressure on Ecuador to default in the summer of 1999. Later on, in 2002, Uruguay successfully resisted similar pressure.

Overly legalistic

The code was also presented in a highly legalistic way, even if it was ostensibly voluntary. If a sovereign going through a restructuring allowed a state-owned pension fund to vote the bonds it owned, creditors could point to paragraph II(A)6(f) in the code, and complain to the IMF or anybody else that the country was contravening commonly accepted principles.

Issuers were keen not to get involved in binding commitments – for one thing they would violate the "case by case" mantra of both the private and the official sector; for another they would constrain countries' freedom of action following default.

It is easy to imagine a code of conduct like the one the IIF proposed in 2003 becoming a formal part of IMF conditionality. If a defaulter wanted an IMF programme and the code of conduct was generally accepted, there would be pressure on the IMF to make adherence to the code a condition for staying on track with the IMF programme and receiving new money not only from the IMF but also from the World Bank and regional development banks.

Since IMF conditionality is normally onerous enough, countries were in no mood to add to the number of things they might be asked to do if they defaulted.

After the meeting, Dallara took it upon himself to construct a document that would be acceptable to the official sector. The first thing to go was the name: the code of conduct was dead, long live the principles for stable capital flows and fair debt restructuring.

The replacement was a much shorter, much less specific document. It "is intended to be general in nature, designed to serve as a set of guideposts," Dallara says.

A 23-member Special Committee on Crisis Prevention and Resolution in Emerging Markets was set up, under the chairmanship of de Larosière and Rhodes, along with a 24-member Working Group on Crisis Resolution, chaired by Tom de Swaan of ABN Amro and including, alongside de Larosière, Bob Hormats of Goldman Sachs and Cees Maas of ING. Buy-siders were invited too, including El-Erian, but he made few if any of the meetings. In any case the drafting of the principles was largely left to Dallara and the IIF's director of emerging markets policy, Sabine Miltner.

Critics of the process will only speak off the record, often because they answer to board members of the IIF and have come under a great deal of pressure to unite behind Dallara and his principles. He has angered many market participants in the way that he went finalized the principles, but no-one sees much to gain from criticizing him or the IIF in public.

Still, Dallara's critics are unanimous in the substance of their criticism. First, they say, he consulted so many people at various stages that essentially no-one but he and Miltner was fully aware of who was saying what about the principles. The issuers, including Mexico's García, say they were closely involved from the beginning, but García admits he only had one meeting with investors, at which views were exchanged but without substantive negotiations on the principles. In his day-to-day conversations with investors, he says, the issue was never addressed – debate took place through the IIF, rather than directly between issuers and their bondholders.

Talking to García, it certainly doesn't seem as if the differences between Mexico and the private sector on key issues such as exit consents are insurmountable. García says he doesn't want to use the word "coercive" without defining it but that he would be happy to state that if he didn't need to use exit consents (for instance, if the bonds in question all had CACs) he wouldn't do so. He also doesn't want to agree to normative language on exit consents – statements that say that debtor countries "should" or "must" behave in a certain manner.

The Emerging Market Creditors Association (Emca), meanwhile, seems happy losing the normative statements about coercion found in the original code, and is content to say simply, that too much use of exit consents is not a good idea.

In the final principles, exit consents are not mentioned at all. Investors now fear that if and when a country uses coercive exit consents in future, its advisers will be able to point to the principles and, with an innocent look on their faces, say that the principles, agreed to by the private sector, say nothing about such behaviour being bad. Such exit consents, meanwhile, would strongly pressure bondholders to enter into an exchange offer they disapproved of.

Leaving out the experts

Critics also charge that rather than enter into a genuinely collaborative process in which experts from all parts of the market hammered out a mutually acceptable draft, Dallara generally consulted with important and busy executives instead of legal, regulatory and other experts with first-hand experience of best practice in drafting market-related documentation.

Indeed, there is a world of difference between the legalese of 2003's code of conduct and the document Dallara circulated to the private sector in March 2004. The new document was largely written in the simple present ("all parties agree to cooperate"; "debtors also commit to avoiding exchange controls") which left open the question of which parts were normative and related to the future, and which simply statements of present-day facts.

And if the issuers had worried that the code might become part of IMF conditionality in 2003, it was the investors who were worried about the same thing in 2004.

If the principles are adopted by the official sector as embodying best practice in debt restructurings, creditors worry, then creditor-unfriendly actions that aren't frowned on in the principles might implicitly be condoned. If the IMF forced issuers to adhere to the principles, they could still use coercive exit consents, say, and refuse to pay the costs of a creditor committee, while still staying in line with de Larosiere's "quintessence of what is good".

"The problem of the dog that isn't barking is more dangerous than what's in the document," says a creditor. "If the list excludes an important positive way to do things, that could be material to some workouts. Borrowers' counsel will advise the borrower to make reference to the absence of that which was not listed. Deficiency by absence may be a big problem."

Many things that are extremely important to investors are absent from the principles. Chief among them are detailed rules of engagement following a default: the principles don't even go as far as the legally binding clauses in the bonds of Hungary and Latvia, nor do they encourage issuers to include such clauses in the future.

Hungary's bonds, following Ipma's lead, provide for 50% of bondholders to vote to appoint a creditor committee, unless more than 25% of bondholders object. They also say that the issuer will pay reasonable fees and expenses, including those of legal and financial advisers, within 30 days of being invoiced. The principles, by contrast, merely note (inaccurately, if bond rather than loan restructurings are considered) that "past experience demonstrates that when a creditor committee has been formed, debtors have borne the reasonable costs of a single creditor committee".

The principles also water down the language on the IMF, so that where the trade associations wanted the principles to state that "sovereign debtors and private sector creditors rely upon the IMF not to encourage a sovereign debtor to default", the final version says that "in cases where program negotiations with the IMF are under way or a program is in place, debtors and creditors rely upon the IMF in its traditional role as guardian of the system to support the debtor's reasonable efforts to avoid default and not to give any appearance of encouraging a debtor to default". Enjoining the IMF not to give any appearance of encouraging default is ambiguous.

More generally, the principles stay silent on matters that investors are upset about. In the words of one observer: "When a code is silent, it is ratifying the status quo."

Discontent first came to a head on August 19, when the IIF sent an email signed by Dallara, blind-copied to recipients, announcing that trade-association talks had ended and that the items the creditors had been asking for would not be included in the final principles.

In an extraordinary show of spur-of-the-moment collective action, the trade associations replied with a scathing email to Dallara just five days later. It began:

"We, representatives of the Securities Industry Association, The Bond Market Association, the Emerging Markets Traders Association, the Emerging Markets Creditors Association, and the International Securities Market Association, were extremely disappointed to learn from your below 'Dear Colleagues' e-mail of 19 August that you had circulated a revised draft of the Principles for Stable Capital Flows to Emerging Markets to issuers, and possibly to others, without having given any of us, not even the small drafting committee, the opportunity to review the draft before sending it out.

"In specific response to your email, our trade associations are unfortunately unable to support the unagreed draft you have circulated to issuers."

The email attached a substantially revised set of principles that the five trade associations said they could agree on.

Dallara says that since the email was sent, the organizations have found more common ground with the IIF and the principles. The most concerned market participants, however, deny that their opinion has changed at all. This communication is evidence of there being much more than mere niggling worries among the signatories. They took it upon themselves to pick a fight with a fellow trade organization with leadership at the very highest levels of the banking community – and presumably would not have done so had they been merely ambivalent on the principles.

As the email circulated, more than one observer remarked on the irony that although the principles extolled the virtues of transparency and cooperative good-faith negotiations, the process leading to their creation seemed to embody the opposite.

Dallara keeps his cool

Even so, the email was clearly an opportunity for Dallara to embrace the consensus that he had managed, albeit inadvertently, to create among the trade associations. The principles, even in their revised form, were not what the associations would ideally have wanted: the revision was rushed together in five days, and the signatories to the email would have much preferred a lot more time to go over the issues and consult a lot more people before arriving at a final version.

Dallara, instead, seemed utterly unfazed by the email, and barged ahead regardless. In fact, say his critics, he started exerting a huge amount of pressure on the trade associations, calling up their board members – many of whom are also on the board of the IIF – and asking why they were being unnecessarily obstructive. It looks as if the phone calls largely worked: although the trade organizations were not present at last month's IIF press conference to endorse the principles, they will not oppose them, either. What one Emca member characterizes as "a deafening silence" will probably be considered acquiescence by most of the official sector.

Some of the conflict could be attributed to competing aims: there was a huge amount of vagueness as to what exactly the problem was that the new principles were meant to be a solution to. At no point was the "gap in the architecture" clearly identified or defined, which meant that different people were working to achieve different things.

A key problem remains that bondholders are naturally much more difficult to get together than a consortium of banks. Debtors like it this way: their investor relations programmes are generally one-way dissemination of information, rather than a dialogue between borrower and investor. Mexico's García even says that he would only be interested in negotiating with a bondholder committee "if its decisions are binding on the bondholders" – a condition he knows is unlikely ever to be met.

So a lot of market participants – both bondholders directly and their securities industry bankers – were hoping that the IIF's principles would help do the job that Rhodes did in the 1980s, of getting creditors around a table with the debtor, within a clearly structured framework designed to hammer out a resolution to a debt problem.

Such a hope might not have been realistic. Given the fight over exit consents, for instance, it could well have been impossible to get many emerging-market borrowers to agree to such a framework. Many bondholders, however, would rather abandon the project entirely rather than accept what they consider to be half-baked principles.

Other participants, especially from the secondary-market perspective, were more interested in promoting investor confidence in the integrity of the market. Scandals have been all too common on Wall Street of late, and there was definitely a desire to rid the market in emerging sovereign bonds of its Wild West reputation.

The key to both problems, however, is the same: in a word, process. If investors can know with a high degree of certainty what is meant to happen in the event of a default, the underwriters will worry less about lawsuits, the bondholders will worry less about being treated in such a cavalier fashion as they have been by Argentina, and the issuers should be able to access a much larger pool of capital.

The situation in Argentina, indeed, has overshadowed the whole course of the development of the principles. Dallara, García and the others concerned in drafting the principles are adamant that they are not directed at Argentina, and should be considered useful only for the future. But at the same time, Argentina's dismissive treatment of bondholders has increased the desire to prevent a similar situation occurring again. The problem, from the point of view of the process's critics, is that in the urgency to make sure something is done, the IIF ended up agreeing to something that could be harmful for private-sector investors.

The issuers, of course, did not want to build too much certainty and predictability into the principles. Essentially, signing on to such a set of principles would mean giving up an option to behave in a market-unfriendly manner – an option that has value even if it is never exercised.

In general, the official sector is unsympathetic to bondholders' concerns – and, in the case of G7 countries, it can be downright hostile. Debt restructurings are often a zero-sum game, which means that the Paris Club, the IMF and bondholders are all fighting over their shares of a decidedly finite debt-service pie in any default.

Unjustifiable derision

A common refrain in talking to finance ministry types, from both G7 and borrowing countries, is a certain amount of derision over what they see as bondholders' obsession with being reimbursed the cost of their lawyers in restructuring negotiations. We're talking billions of dollars-worth of debt here, they say, and these people are obsessed over legal fees?

But in fact there is a good reason for bondholders to be exercised about legal fees – and it's exactly the same as the holdout problem that the official sector got so worked up about when it proposed the SDRM. If creditors have to pay their own fees, any individual bondholder is better off not joining the creditor committee, letting the committee bear the costs, and simply accepting the exchange offer when the final deal has been hammered out. Holdouts, once again, get a better deal: just as those who don't enter into a bond exchange have typically been paid in full, those who don't pay for legal fees still get the same deal, in the end, as those who do.

It is worth noting that the IIF's board, largely commercial bankers, is the one part of the emerging-market creditor community that doesn't have significant collective action problems. What's more, investment banks have a vested interest in their relationships with issuing countries.

Banks, then, are primarily interested in maintaining close relations with emerging-market sovereigns – something that is very much at the heart of the principles in their final form. And now that the G-20 has been formed, they have the perfect partner with which to cement that relationship.

In any case, the IIF often seemed concerned less with the content of the principles than with their timing, say its critics. Dallara very much wanted something final before the IMF/World Bank meetings at the end of September, and certainly by the G-20 meeting in Berlin in mid-November. After that, it was felt, it would be much harder to get the G-20 to recognize the principles, since China would have the chair rather than Germany. There was also speculation that either Anne Krueger, at the IMF, or John Taylor, at the US Treasury, might not stay in their jobs for a second Bush term, and that Dallara wanted to position himself to replace them by helming a major success story.

Dallara has now become a great friend and admirer of the G-20. "The G-20 have played a prominent role in catalyzing and encouraging the development of these principles," says Dallara: it's clear that he sees the official sector more as people to negotiate with than to negotiate against. While the rest of the private-sector trade organizations were trying to come up with a united front, after all, Dallara was talking to the issuers, trying to work out what would be acceptable to them. But is what he has produced useful to the wider market?

"It may be seen as pretty general, but I can tell you that it's a pretty good exercise," says de Larosière. "I've never seen such a collaboration between the private sector and the official sector in a written form."

With friends like these, the bondholders can be forgiven for thinking there's little need for enemies.

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