By Josh Macfarlane
Tango 01—Argentina’s equivalent to Air Force One—hasn’t gotten much air time recently. The plane was grounded in 2013 by the country’s former President Cristina Kirchner, who was allegedly afraid that foreign creditors would seize the jet. Ms. Kirchner’s fears were not unfounded considering the country twice defaulted on its sovereign debt repayments and had failed to settle with its holdout creditors. The turbulence over the Tango 01 is one of the many consequences of Argentina’s prolonged debt crisis, a hallmark of Ms. Kirchner’s presidency. Earlier this year Tango 01 was retired by President Mauricio Macri, Ms. Kirchner’s successor, who has eschewed Ms. Kirchner’s intransigence in dealing with foreign holdouts in favor of a more conciliatory approach. This change of tact has largely paid off. But considering it has taken 15 years to resolve, one must ask: Could this mess not have been sorted out earlier? Maybe, had Argentina’s sovereign bonds included a novel contract provision known as a Collective Action Clause (CAC).
CACs are increasingly lauded as the ex-ante remedy to sovereigns on the precipice of default, as they facilitate meaningful debt restructuring. They are essentially contractual provisions that allow bond issuers to modify key terms of the bond at a later date, most commonly in the form of “haircuts,” which are reductions in the bond’s original value. Assuming a supermajority of bondholders agrees to the modified terms (because something is better than nothing), they become binding on all bondholders. This overcomes holdout problems where one recalcitrant bondholder is free to reject new terms and demand repayment in full (plus interest). In the case of Argentina’s bonds, which, notably, did not include a CAC, a U.S. federal judge ruled that the country could not pay interest on the restructured bonds until it settled with the holdouts; Ms. Kirchner’s failure to do so led to perpetuating default. (Note: Argentina’s bonds were issued under New York law, hence U.S. jurisdiction applied.) This legal precedent not only hurts the sovereign debtor by excluding it from international capital markets, but it also harms the supermajority of creditors who are enjoined from collecting interest and principal payments on their bonds. CACs are of particular importance in the aftermath of this ruling, as in their absence, a single bondholder can wreak havoc on debtors and fellow creditors.
The world has taken note as Argentina, Greece, and others have defaulted on bond payments with severe consequences. CACs have readily been adopted as the preventative remedy, becoming must-have provisions in sovereign debt offerings. Mexico was an early harbinger when, in 2003, it included an early CAC iteration in its sovereign bond offering. More recently, the EU mandated in 2012 that all Eurozone sovereign bonds must include standardized CAC provisions, lest the leaders of Europe be forced to fly commercial like Ms. Kirchner.
So, are CACs the panacea that debtors and creditors have been waiting for? Not necessarily. For debtors, CACs only offer a prospective benefit as they cannot be introduced retroactively. Hence, sovereigns with outstanding issuances remain liable to potential holdouts, e.g., Argentina. In future bond offerings, where CACs can be included, debtors on the verge of default must nevertheless persuade a supermajority of bondholders to assent to the restructured terms. This poses substantive and logistical problems. First, haircuts can’t be too drastic otherwise creditors will not agree to them. Second, bonds are issued across borders and in different currencies, which can create communication problems – apathetic bondholders may simply not reply to a foreign debtor’s solicitations. In such instances, bondholder silence may be misconstrued by the debtor as a demurral, which might result in the debtor either ignoring these bondholders or considering them to be holdouts and offering them unnecessarily favorable terms.
As for bondholders, some undeniably feel that that CACs swing the pendulum too far in the opposite direction, stripping them of their right to demand payment in full and, assuming supermajority approval, foisting new terms on them. One might expect this to be offset by higher bond yields because of the heightened risk that creditors assume; however, empirical evidence suggests otherwise. Some creditors, notably those who already agreed to the restructured terms, will be pleased that fellow bondholders cannot secure a better deal by simply digging in their heels. Look at Argentina, where the absence of a CAC resulted in some creditors incurring haircuts of around 70% compared to the holdouts’ 25%. Also, bondholders who are citizens of the issuing sovereign, and who are normally more inclined to agree to haircuts, like the fact that CACs prevent foreign holdouts from dragging their country into default.
While CACs are not perfect, they provide the best solution in the absence of international law governing sovereign default (a much talked about topic, but a seemingly impossible endeavor). Granted, CACs are utilitarian in nature, and the greater good seems to be allowing a country to restructure its debt, subject to supermajority approval, by depriving would-be holdouts the ability to derail the process and instigate economic turmoil. Moreover, CACs give sovereigns the tools to resolve their own debt crises, , making them less reliant on the International Monetary Fund – which often provides bailout funds in exchange for the adoption of damaging austerity measures.
Expect CACs to continue growing in popularity until they became integral provisions in all sovereign debt offerings. Perhaps Mr. Macri’s successors will be able to bring Tango 01 out of retirement, but in the meantime, he’s flying coach.
Josh Macfarlane is a 2017 J.D. candidate at Harvard Law School and a Feature Editor of the Harvard International Law Journal.