Legal Issues 101: Collective Action Clauses

Posting some old stuff this week.


In sovereign loan agreements there are several critical legal clauses that can impact how debt is treated in the case of a debt restructuring.  Some of these terms do not receive much attention in the drafting process, but may have a significant impact in the event of default, restructuring or vulture fund litigation.  The ALSF is publishing a series of brief articles where it will focus on one particular clause each month with the goal of educating our readers on how this term fits into the larger picture of the debt agreement. The first installment focused on Pari Passu Clauses, next month’s installment will focus on negative pledge clauses.

Collective Action Clauses (CACs) allow a majority of bondholders to act on behalf of the entire group of bondholders.  More specifically, CACs allow a qualifying majority of bondholders to agree to restructure the payment terms on their bonds.  If the majority threshold is reached, the terms become binding on the dissenting bondholders.  Here are some examples of CACs from emerging markets.

CACs were invented as a way to protect sovereigns from holdout commercial creditors who refused to participate in sovereign debt restructurings.  In particular, without CACs, vulture funds often would buy up non-participating debt in restructurings and sue the sovereign for the full-value of the debt to the detriment of the other bondholders or with the threat of derailing the restructuring process.  CACs most recently entered the news with respect to the Greek debt restructuring process as a tool to ensure that participation in the restructuring would leave no bondholders left behind.

Without a CAC, in the event of a debt restructuring the sovereign may not be able to modify the terms of the debt instrument without obtaining 100% participation of the bondholders.  With a CAC, the sovereign can modify the terms with a lower participation (66-90% participation depending on the specific clause).  With a CAC in place, the sovereign has a strong legal mechanism to force vulture fund creditors to comply with the terms of a restructuring that a super majority of other bondholders deem acceptable.

The CACs alone do not allow the sovereign to change the terms of the loan agreement on a whim.  CACs are in place to allow a sovereign a chance to restructure the terms of an agreement rather than be held hostage by a small minority of bondholders (e.g. vulture funds).

There are several points of negotiation that must be considered when including a CAC in an agreement: (1) what is the voting threshold (66, 75, 85 or 90 percent); (2) are there reserved matters which may require a higher voting threshold; (3) does the vote relate only to a single issue or does it aggregate across other bond issuances (previously issued bonds with varying term lengths and interest rates); (4) who can vote (disenfranchisement); (5) governing law; (6) coercive exit consents; (7) who will be the administrator; and (8) anti-manipulation provisions.  This is just a sample of some of the specific legal issues within collective action clauses that must be addressed.  The list above does not cover where the collective action clause actually goes (e.g. trust deed or “master” fiscal agency agreement) which is a key decision for the drafting of the agreement.

The practical implications of these clauses only come into effect when there is the need to amend the debt issuance.  So the sovereign must balance the need to conclude the financing agreement against the importance of these provisions in the case of distress during negotiations.

Posted in Uncategorized

Legal Issues 101: Pari Passu Clauses

In sovereign loan agreements there are several critical legal clauses that can impact how debt is treated in the case of a debt restructuring.  Some of these terms do not receive much attention in the drafting process, but may have a significant impact in the event of default, restructuring or vulture fund litigation.  The ALSF is starting a new series where it will focus on one particular clause each month with the goal of educating our readers on how this term fits into the larger picture of the debt agreement.

The first clause that we will look at is the “pari passu” clause.  Pari  passu is a Latin phrase that means “with an equal step” or “on equal footing.”  This clause is related to the seniority of the underlying debt.  In general, a pari passu clause is intended to rank all creditors equally in the event of a default or restructuring.  It requires the issuer to treat all senior assets equally without any display of preference. The conventional use of this clause is to ensure that the borrower does not take on any obligations that rank legally senior to the debt instrument taking the clause. 

Here is a typical pari passu clause in a cross-border agreement:

The Notes rank, and will rank, pari passu in right of payment with all other present and future unsecured and unsubordinated External Indebtedness of the Issuer.[1] 

On its own, the clause seems harmless and plays a key role in commercial debt agreements.  However, in the sovereign context, its role is less clear and the subject of debate among legal scholars.

These clauses take on particular importance in the context of commercial creditor actions against sovereign debtors and vulture fund litigation. In an enforcement action initiated by Elliot Associates, L.P., a New York based hedge fund, against the Republic of Peru, a Belgian court interpreted the clause to mean that the debt must be paid pro rata among all creditors.  

This interpretation by a Belgian court on an issue of New York law has provided a tool for vulture fund creditors.  Following the ruling in the Elliot case, Argentina, Democratic Republic of Congo, the Republic of Congo, and Nicaragua all faced claims brought on the interpretation that the pari passu clauses in the sovereign debt agreements required that the creditors be paid on a pro rata basis.  This interpretation gave holdout creditors in debt exchanges (a common tool for restructuring sovereign debt) a powerful legal argument that potentially prevents governments from successfully restructuring their debt.

The practical implications of a “boiler plate” legal clause can be far reaching as seen in the context of the pari passu clauses.  Next month, we will look at Collective Action Clauses to see how they can assist governments in preventing holdout creditors from delaying the debt restructuring process.

[1] Buchheit, L. and Pam, J., Georgetown L. Rev. Working Paper,  The Pari Passu Clause in Sovereign Debt Instruments, 2003.

Posted in Uncategorized

Greek Debt Negotiations – Opa!

I’ve been following the Greek Debt Negotiations and it’s been a really fascinating story. It’s amazing how much the derivatives market has complicated the process.

Normally when a country defaults, a debt exchange often takes place. That is the original creditors would trade in their old debt for new debt with new payment terms and usually a reduction in the amount of principal on the coupon (“haircut”). A creditor will usually agree to an exchange like this if it thinks that it won’t get paid any other way, and collecting 50 cents is better than getting nothing.

There are several types of creditors: bilateral (individual countries), multilateral (e.g. World Bank and IMF), commercial banks, and other private investors. Each of these creditors have different incentives to settle with Greece and move on from the default. Some are more willing than others. In particular, some private creditors have had their situations complicated by their hedging positions.

Enter the credit default swaps…

So as explained earlier, a credit default swap (CDS) can be thought of similar to a type of insurance policy, when the debtor defaults, the creditor swaps positions with the CDS counter-party and is effectively made whole by the counter-party.

Private sector creditors are being represented by the IIF, Institute of International Finance, a global association of financial institutions that has the incredibly difficult challenge of representing the private creditors in the negotiations.

Here is where things start to get complicated, every creditor has a different agenda. And based on how the debt agreements are structured (specifically whether or not there is a pari passu clause or collective action clause) some, all or most of the creditors are required to approve a deal. Given that a private creditor could withdraw its permission to allow the IIF to negotiate on its behalf, the IIF is tasked with balancing many competing interests.

What are those competing interests? Well it depends on who is holding the debt.

If its a commercial bank with significant interests in doing business with the government of Greece or doing business in Greece, they are more likely to go along with the consensus and settle the matter as quickly as possible in order to preserve the relationships with the government.

If its a hedge fund or distressed debt fund who purchased the debt on the secondary market, it depends on the price they paid and their individual expectations of IRR which will dictate how hard they negotiate.

If its a pension fund (or a trust) with fiduciary obligations to its beneficiaries, they will have competing interests to ensure that they do not violate their obligations and get the best deal possible.

And it gets really complicated when any of these parties holds a credit default swap on the debt. Because if they hold a CDS, they may have an incentive to settle at a lower amount in order to trigger a default under their agreement and then be made whole. So instead of settling for a 50% cut or a structure that doesn’t technically qualify as a default, they may be incentivized to actually structure a deal which is likely to trigger their protection.

Which begs the question, when is a default a default in a CDS? This is where things continue to get murky because the CDS market is unregulated, each contract may have differences in it. Now its most likely the case that a 50 or 60% haircut may be enough to trigger a technical default and initiate the CDS protection; however, many of the private creditors don’t want this because they are still trying to determine what their potential exposure is on the CDS side of things. It’s likely that many of the creditors are on both sides of the swaps or represent clients who are on the other end of a swap. So even within a bank, there may be conflict on which way to negotiate. And to make matters worse, the CDS counter-parties, who aren’t readily identifiable, don’t have a separate seat at the table.


Posted in credit default swaps | Tagged , , , ,

Paris Time Lapse Photography

I saw this earlier today and thought it was an excellent video. It was done entirely using still photographs and it has music from The XX.

Le Flâneur (music by The XX) from Luke Shepard on Vimeo.

Posted in Photography | Tagged ,

Treasure Island

I’m going to use this blog as a proxy for my random musings and thoughts.  I’m calling it Tired of Doctors because, quite frankly, I’m tired of doctors, I mean really, who enjoys going to the doctor?

I’m currently reading Treasure Islands: Uncovering the Damage of Offshore Banking and Tax Havens by Nicholas Shaxson.  The prologue begins in Gabon and tells the tale of how interconnected “Western” interests are to African nations, and in particular, corrupt African leaders.  I’ve only made it through a few chapters so far, but I must say the book is quite eye-opening.  The amount of money that passes through offshore financial centers is staggering.

I started reading this book as I’ve been following the stories about the stolen assets from the recently fallen North African leaders such as Ben Ali, Mubarak, and Gaddafi (anyone who can tell me how to properly spell his name would be much appreciated).  The amounts of money that have been allegedly misappropriated by these leaders and their families is staggering.  For Tunisia’s Ben Ali, it is estimated that his family wealth is over 12 billion US Dollars.  For Mubarak, it is estimated that his family wealth is over 70 billion US Dollars.  Gaddafi’s wealth is unknown, but I’ve seen reports that as much as 30 billion US Dollars was frozen in the United States alone.  For comparison, the entire capital base of the African Development Bank is less than the combined wealth of these three leaders.

I’m curious to see where Shaxson goes with this book, part of me wonders if it will lead to any meaningful reform or whether it will serve as a blueprint for those who have wanted to shelter money but don’t know where to begin.

I’ll post more updates about the book as I continue to read.

Posted in Books, Money Laundering, Stolen Asset Recovery

Derivatives Don’t Cause Massive Losses. Only People Cause Massive Losses.

Such was the thrust of testimony before a Senate committee this week by Robert Pickel, head of the International Swaps and Derivatives Association (ISDA), and Richard Lindsey, former president of Bear Stearns’ brokerage unit, regarding the role of credit default swaps (CDSs) in the current economic crisis. Said Lindsey,

“[R]isks [are] not created by derivatives. They [are] created by
individuals or corporations making bad choices when using derivatives.”

Given recent events, perhaps it would be churlish to point out that derivatives, particularly when combined with massive leverage, can magnify and concentrate the effect of those bad choices (as the travails of AIG have amply demonstrated). Regarding CDSs, “Black Swan” author Nassim Taleb noted this week,

“We refused to touch credit default swaps. It would be like buying
insurance on the Titanic from someone on the Titanic.”

Even as TARP has morphed from an asset purchase program to a recapitalization plan, financial market turmoil and volatility remain unabated. Many observers blame the fear that continues to grip the financial world on the dawning realization of the threat posed by the $62 trillion (by some accounts) CDS market. The exponential growth of the CDS market over the past few years, its opacity and lack of regulatory control, and the fear of counterparty risk in the wake of Lehman’s failure have made CDSs the latest instrument to raise the spectre of further massive losses at financial institutions and hedge funds. As investors, politicians and regulators cast about for root causes of the current crisis and steps that need to be taken going forward, a harsh light is being shone on CDSs.

CDS proponents are pushing back. Messrs. Pickel and Lindsey, while conceding the need for some changes in the market (such as a central clearing house for trades), reject the notion that direct government oversight of the market is necessary or appropriate. Similarly, The Depository Trust and Clearing Corporation issued a statement last week that strongly disputed the size and opacity of the CDS market, claiming that the $62 trillion notional value amount represents double counting (i.e., adding in both sides of a single trade), and that the real number is approximately $35 trillion. The DTCC also takes issue with the potential losses that will result from Lehman’s bankruptcy. While some analysts have that predicted total losses arising from protection sold against a Lehman default could be as high as $400 billion, the DTCC contends that virtually all of the Lehman trades will net out, and that required payouts will not exceed $6 billion.

We will find out very shortly who is correct. The financial markets are now directly confronting the concerns raised months ago in this space (and many others). An auction conducted last week by ISDA produced a settlement price for Lehman debt of less than ten cents on the dollar, which means that Lehman protection sellers must pay their counterparties over 90% of the par value on the underlying bonds. Did protection sellers properly hedge their risks by buying protection coextensive with their potential exposure? If they did, will their counterparties be able to make good?

Settlements are required to be made next week, on October 21st. After that, the financial markets can begin to focus on the potential impact of the WaMu CDSs. That settlement auction is scheduled for October 23rd.

Posted in Finance, Overhedged | Tagged , , | 1 Comment

Perils of Paulson

Henry Paulson and Ben Bernanke may be escaping from the precipice of one horrific calamity, only to be breathing a sigh of relief just as an even worse catastrophe looms. The plan to buy distressed mortgage related assets and derivative products, referred to by some as TARP (the Troubled Asset Relief Program) and by others as MOAB (the Mother of All Bailouts), may provide some short term relief to the global financial markets, which perhaps will suffice to head off greater disaster. However, putting aside the concerns raised regarding the wisdom and efficacy of the proposal, the larger question remains as to how to mitigate the threat posed by the still-completely-unregulated $62 trillion credit default swap market.

As discussed in this space before, a credit default swap (CDS) is a swap agreement whereby the holder of debt may purchase protection from a third party against the debt issuer’s default. The seller thereby takes on the credit risk of the issuer, and the buyer replaces the credit risk with counterparty risk. As CDSs have evolved from hedging devices into speculative instruments (buyers making short bets without actually owning the underlying debt), the market has grown exponentially. The perils posed by such rapid growth in an unregulated over the counter market were fast becoming apparent last year. Several months ago, I wrote:

Given both the immense size of the CDS market and how poorly risk in other asset
classes was assessed and priced over the past several years, CDS counterparty
risk is accurately being called the “sword
of Damocles
” hanging over the financial services industry. The term
“counterparty risk” will likely soon move alongside “subprime borrower” as a
disquieting addition to the financial lexicon.

Fear of exposure to the CDS market led to the Federal Reserve’s willingness to backstop in part the JP Morgan takeover of Bear Stearns and the rescue of AIG. Lehman Brothers was permitted to fail because its CDS exposure appeared to present less of a systemic threat.

CDS market participants and the International Swaps and Derivatives Association have been working for months to increase transparency and reduce counterparty risk. As of today, there are no standardized settlement procedures, and the market has never been forced to deal with a major default. The obvious need is for the creation of a central exchange. Unfortunately, the development of such a clearing system will probably not be in place until early 2009.

In the meantime, it is anyone’s guess where the major fault lines lie. The bailout of Fannie and Freddie triggered “credit events” under an unprecedented number of CDS contracts – as much as $1.4 trillion by some estimates. However, because the conservatorship effectively assures full payment of the underlying Fannie/Freddie debt, the settlement amounts on the trades (the difference between par and market value that the CDS seller owes to the CDS buyer) should be $0. Accordingly, there will be relatively little economic impact as the major market participants seek to sort this all out.

The financial markets may not be so lucky the next time a company whose debt is the subject of over $1 trillion in CDSs goes into default. If, for instance, one of the Big Three automakers were to seek bankruptcy protection, its bonds will almost certainly be worth substantially less than par, and the settlement amounts owed by CDS sellers to CDS buyers could be overwhelming. While most trades will net out, the failure of a financial institution or hedge fund to make good on its obligations as a protection seller could trigger another financial crisis equal in scope or greater to what has been faced over the past two weeks.

It also gives rise to the even more unsettling possibility that the government may be forced to step in and prevent such a major bankruptcy filing. The perils continue. TARP / MOAB may be just the beginning.

Posted in Commentary, credit default swaps