As members of the Eurozone are now acutely aware, the lack of a sovereign debt restructuring regime is one of the most glaring gaps in the international financial architecture. That said, this summer’s decision by a tribunal of the International Centre for Settlement of Investment Disputes (ICSID), which grants a bilateral investment treaty (BIT) jurisdiction over Argentina’s restructuring of its sovereign debt in the wake of its 2001 financial crisis, shows that a de-facto regime may be arising whereby international investment agreements (IIAs) can serve as a way for disgruntled investors to circumvent debt restructuring. This amounts to mission creep on the part of IIAs. Creeping into such territory is too much to take on for the world of IIAs. Sovereign debt restructuring should be left to national governments and international financial and monetary authorities.
This short article discusses how sovereign debt restructuring is seen as grounds for private bondholders to file arbitral claims under IIAs; that safeguards under IIAs are limited, particularly in US IIAs, meaning that it is not clear which measures provide governments with policy space to effectively restructure debt in times of crises; and if claims against sovereign debt restructuring become more widespread they could threaten the already fragile regime for financial crisis recovery. Finally, technical options for reforming treaties to delegate debt restructuring to the proper regimes are outlined.
Background: Debt, the SDRM and CACs
Though it increasingly has a bad name in the current crisis, debt is an important component of economic growth and development. But if it is not managed properly debt can become unsustainable and force nations to default or restructure their loans. At the turn of the century, the International Monetary Fund (IMF) proposed a global mechanism for working out debt problems, but it was rejected by the US government and the global business community. In its place are collective action clauses that have not become widespread and face a number of obstacles to becoming adequate.
If managed appropriately, government borrowing can be an essential ingredient for economic development, and has been for centuries. However, as we are witnessing in Europe, even when nations manage to keep its debt to GDP ratio in good shape, they can still spiral into a debt crisis—simply defined as when a nation cannot (or is no longer willing) to service its debt. Contagion from other crises or herd-like bouts expressing a lack of investor confidence could prevent creditors from rolling over or increasing loans. Moreover, debt is sometimes denominated in a foreign currency, so when interest rates rise or the value of nation’s currency falls (on its own or relative to its neighbors) the cost of debt service can skyrocket.
Even nations with low budget deficits can quickly be affected as governments borrow to bailout frivolous banks or stimulate an economy during a recession, but then experience slow growth and low tax revenue thereafter. These tensions are exacerbated with developing nations that are overly exposed to international financial markets. Any number of the factors discussed above could cause massive inflows of debt and large swings in outflows that can cause financial instability
Coordinated global bailouts have been part of the traditional response to prevent and mitigate debt crises, but receive a great deal of criticism because of their costliness and lack of effectiveness. Europe allocated $1tn in May of 2010, over $100bn in July 2011, and proposes yet another $109bn in its October 2011 package. These bailouts go from the pockets of taxpayers to private creditors. The record on the effectiveness of bailouts is limited at best, with many nations taking years to recover, if at all. Moreover, bailouts can encourage moral hazard where nations and investors will engage in more risky behavior because they think they will be bailed out in the end (Eichengreen, 2003).
Sovereign debt restructuring (SDR) is increasingly seen as an alternative to bailouts. However, the international community views the SDR regime to be greatly lacking. When a sovereign government is no longer willing or able to pay its debts, sovereign restructurings occur during what amounts to a formal change to debt contracts negotiated between creditors and debtors. SDRs (or “workouts”) often take the form of reducing the face value of the debt, “swaps” where new bonds with lower interest rates and longer maturities are exchanged for the defaulted bonds, and so forth. Such workouts are usually highly discounted and result in a loss for bondholders. Losses or discounts are commonly referred to as “haircuts”.
In the early 2000s the IMF proposed a “Sovereign Debt Restructuring Mechanism” (SDRM). The SDRM sought to provide a fair forum for negotiation between bondholders and governments; a standstill clause whereby bondholders can’t yank their money out of a debtor nation in a herd; a facility to provide short-term financing and to prioritise a debtor nations’ debt schedule; and clauses that limit the ability of disgruntled minority bondholders to file lawsuits against debtor nations. The SDRM was swiftly rejected by the US government and the business community.
Instead, the US proposed normalizing the use of collective action clauses (CACs). CACs have the following features: a collective representation component where a bondholders’ meeting can take place where they exchange views and discuss the default/restructuring; a majority restructuring component that enables a 75% “supermajority” of bondholders to bind all holders within the same bond issue to the terms of restructuring; and a minimum enforcement component whereby a minimum of 25% of the bondholders must agree that litigation can be taken. Unfortunately, the majority of the bonds in the Eurozone do not have CACs and even if they did, a restructuring would not be burden free. The International Swaps and Derivatives Association can rule out a CAC and pay out insurance to bondholders instead. CACs also do not apply across bond issuances and thus it may be hard to get agreement on a whole swath of debt that a nation in trouble would like to swap. And it may be the case that CACs are no cover for IIAs.
Hello Argentina: IIAs and Sovereign Debt Restructuring
Readers of this publication know that an increasing number of the more than 2,000 trade and investment treaties that govern international investment flows cover “any type of asset.” What may be news to some is that a recent ICSID panel has seen Argentina’s restructuring of debt in the wake of its 2001 financial crisis as falling under the jurisdiction of the Italy-Argentina BIT. Indeed, sovereign debt is “any kind of asset” and thus a BIT may be a place where investors can seek to recover the full value of their bonds.
When Argentina restructured its debt in 2005 close to 180,000 Argentine bondholders filed a claim under the Italy-Argentina BIT for approximately $4.3bn. Some of those investors settled in a 2010 restructuring and now there are believed to still be approximately 60,000 Italian bondholders seeking upwards of $2 billion from Argentina at ICSID. This September, a majority of a private World Bank tribunal decided that Argentina’s bond restructuring indeed does fall under the jurisdiction of these treaties. The case will therefore continue, despite a scathing dissent from a third member of the tribunal (IAR, 2011). The bondholders seeking their investments through the trade treaty are among the few remaining holdouts.
Box 1 outlines where IIAs can tangle with sovereign debt restructuring. And it is not clear that the small number of safeguard measures in place can assure that a nation can have a debt workout without also getting snared in an ICSID process.
Box 1: IIAs and Sovereign Debt Restructuring
Jurisdiction: If IIAs are deemed to cover “any kind of asset” then it can be argued that sovereign debt falls under the jurisdiction of the treaty.
Expropriation: SDR could be seen as an indirect expropriation because a restructuring reduces the value of the sovereign bond.
Fair and Equitable Treatment (FET): Insofar as FET is seen as protecting investors’ legitimate expectations, a bond swap that was not expected during the initial investment period could be seen as a violation of that standard.
National Treatment: In some financial circumstances, it may be important to treat domestic bondholders differently than foreigners. This could be seen to violate National treatment, however.
The safeguards and exceptions in many IIAs are not adequate enough to provide cover for nations to restructure their debt. For most cases the only possible safeguard are “essential security” provisions. A handful of the United States’ treaties have an annex that discusses sovereign debt restructuring that is very limited.
It may be possible that a nation can claim that actions taken during a financial crisis are measures needed to protect the ‘essential security’ of the nation. Language like Article 18 of the United States Model BIT is found in many treaties:
… to preclude a Party from applying measures that it considers necessary for the fulfilment of its obligations with respect to the maintenance or restoration of international peace or security, or the protection of its own essential security interests (USTR, 2004).
The article does not mention economic crises per se, but “all tribunals that have considered the matter thus far have interpreted the rules broadly enough to include such crises” (Salacuse, 2010: 345). However, tribunals differ greatly over how grave the difficulties may be. In Argentina, again, tribunals came to opposite conclusions, and only one of three tribunals ruled that Argentina could not be held liable for actions it took to halt its crisis. A key matter is whether or not a measure by a nation to stem a crisis can be seen as “self-judging”. In other words, can the host nation using the control be the judge of whether or not the measure taken was necessary to protect its security. The language quoted above in the 2004 Model BIT, which says “that it considers” is now seen as to mean that a measure is self judging (because of the “it”), but Argentina’s BITs with the United States and others did not include as precise language at the time (Salacuse, 2010).
Some of the recent IIAs negotiated by the United States clearly define sovereign bonds as covered investments and provide explicit guidelines for the interaction between SDR and certain IIAs. The US is usually reluctant to negotiate such guidelines, as it sees CACs as sufficiently safeguarding sovereign debt restructuring. However, when negotiating partners insist, the US is sometimes willing to compromise with an annex.
What is found in the US-Uruguay BIT, and in FTAs with Central America, Chile, Peru, and Colombia is a special annex on sovereign debt restructuring. Though the specific text varies across the treaties with such an annex, they usually prohibit claims against ‘negotiated debt restructuring’, unless an investor holds that a restructuring violates national treatment (NT) or (MFN). Such treaties usually define “negotiated restructuring,” as a restructuring where 75% of the bondholders have consented to a change in payment terms. If an investor does file a claim in the event of a restructuring that is not a “negotiated” one, s/he must honor a ‘cooling off’ period usually lasting 270 days before a claim may be filed. There is no cooling off period for a non-negotiated or negotiated restructuring that violates NT or MFN.
These annexes are not standard in US treaties after NAFTA (NAFTA excludes sovereign debt from the definition of investment altogether). Indeed, the US-Australia, US-South Korea, US-Morocco, US-Oman, US-Panama and US-Singapore agreements included bonds and debt as covered investments but do not include annexes for sovereign debt restructuring.
The Dominican Republic-Central America Free Trade Agreement resembles the Chile FTA much more closely. Like the above agreements, bonds and other debt instruments are considered covered investments under the agreement. Annex 10-A then specifies very clearly that sovereign debt restructuring is subject only to Articles 10.3 (National Treatment) and 10.4 (MFN). The additional cooling off period does not seem to apply and there is no mention of “negotiated restructuring” as a prerequisite.
These annexes can be seen as a step in the right direction given that parties to the agreement recognize that restructuring is a special case, yet they remain far from adequate for at least four reasons. First, CACs will not alleviate the possibility that nations will seek claims for restructuring. As indicated earlier, vulture funds and other holdouts can acquire a supermajority within a bond issuance and neutralize the bond issue and a 25 percent minority can still agree to litigate and arbitrate. Second, the definition of investment and umbrella clauses allow for investor-state arbitration under treaty obligations regardless if such obligations are also covered by domestic law. Third, most restructurings are multi-issue restructurings and suffer from the aggregation problem described above. Again, collective action clauses only apply within a bond issue, not across multiple issues that are often bundled together in a restructuring.
Fourth and very importantly, economists and international financial institutions have repeatedly held that, in contradiction with the national treatment principle, domestic bondholders and financial institutions sometimes needed to be treated differently during a crisis. Prioritizing domestic debt may be in order so as to revive a domestic financial system, provide liquidity and manage risk during a recovery (Gelpern and Setser, 2004, 796).
Reforming the Mission
This short note has outlined how some IIAs have provisions that may prevent the ability of financial and monetary authorities to effectively manage debt crises. Argentina is thus far the only country subject to claims, but the numerous investment treaties negotiated since the Argentine crisis of 2001 and the fragility of the global financial system unfortunately mean that similar cases may arise in the future.
The following are three non-exclusive policy remedies that would enable IIAs to grant nations the policy space to conduct effective SDRs in the future:
- Exclude sovereign debt from IIAs. The exclusion of sovereign debt from “covered” investments under future treaties would relegate sovereign debt arbitration to national courts and to international financial bodies. Some IIAs already exclude sovereign debt, such as NAFTA and others. Argentina’s new model BIT is reported to be moving in this direction as well.
- Clarify that mitigating financial crises is “essential security”. Clarify that the Essential Security exceptions cover financial crises and that sovereign debt restructuring taken by host nations is ‘self-judging’ and of ‘necessity.’
- State-to-State dispute resolution for SDR and crisis related instances may be more prudent than investor-state arbitration given that governments need to weigh a host of issues in such circumstances. States attempt to examine the economy-wide or public welfare effects of crises whereas individual firms rationally look out for their own bottom line. Investor-state tips the cost-benefit upside down, giving power to the “losers” even when the gains to the “winners” (the larger public and the future of a nation) of an orderly restructuring may far outweigh the costs to the losers.
Author: Kevin Gallagher is Associate Professor, Department of International Relations, at Boston University. This note is based on a longer report on the subject titled “The New Vulture Culture: Sovereign Debt Restructuring and Trade and Investment Treaties,” IDEAS Working Paper no 2-2011.
Eichengreen, Barry (2003), “Restructuring Sovereign Debt,” Journal of Economic Perspectives vol. 17(4), pages 75-98.
Gelpern, Ann and Brad Setser, (2004), “Domestic and External Debt: The Doomed Quest for Equal Treatment,” Georgetown Journal of International Law, v35, n4, 795-814.
Investment Arbitration Reporter (IAR), “Argentine sovereign bond arbitration at ICSID” Vol. 4, No. 16, November 3, 2011.
Salacuse J (2010). The Law of Investment Treaties. Oxford. Oxford University Press.
United States Trade Representative (2004), US-Model BIT, Washington.