2.01  One cannot properly comprehend sovereign debt litigation without first placing it in the context of the contractual provisions commonly found in sovereign bonds. The documentation of external bonds has gone from strength to strength over the last decade.¹ External sovereign bonds now include a whole array of clauses, such as collective action clauses (CACs) in various manifestations, choice of law, and choice of court provisions, all of which are designed to facilitate the orderly restructuring of sovereign debt and to ensure certainty in the resolution of disputes.

2.02  Nowadays, the almost ubiquitous market practice is to include CACs in sovereign bonds. CACs are designed to ensure the orderly resolution of sovereign debt crises and overcome the risk of holdout strategies by minority bondholders. Their introduction into sovereign bonds resonates with the ‘contractual approach’ to sovereign debt restructurings, whereby the intricacies of the sovereign debt workouts are addressed ex ante—through the introduction of various contractual clauses.

2.03  Among various CACs, one type of clauses—majority action clauses—stand out in that they provide for the ‘democratic’ governance by the majority of bondholders over and against the will of the minority. Pursuant to this clause, a majority of bondholders (most commonly 75%) has the power to amend the financial terms of bonds and consent to a restructuring of the debt, with binding effect for all bondholders. It is generally assumed that these clauses weaken the chances of holdout litigation in that a bondholder who does not have a blocking position of 25% of bonds is restrained from rebelling against the will of the majority and holding out.

(p. 48) 2.04  Commonly, in English law governed bonds, the majority of bondholders may modify the bonds if it has amassed the consent of 75% of bondholders, although some bonds may call for the consent of fewer bondholders.² Pre-2003, English law governed bonds contained a diminishing quorum requirement: if less than 75% of bondholders were present at the first physical meeting of bondholders, the second meeting required a mere 25% quorum and as low as 18.75% of bondholders could have amended the bonds.³ This stands in sharp contrast with those bonds that require a unanimous consent of all the bondholders to amend the financial terms of the sovereign debt issuance (pre-2003 New York law governed bonds, German law governed bonds, etc).⁴

2.05  Since 1 January 2013, all eurozone bonds should contain majority action clauses,⁵ both in foreign-law and domestic-law governed bonds. The eurozone model clause provides that sovereign bonds might be amended by the consent of the supermajority of 66⅔% of the holders of all outstanding bonds, or 75% of bondholders present at a bondholder meeting.⁶ Again, such a decision would have binding effect on the non-consenting minority of creditors (Art 4.12).

2.06  Majority action clauses generally contain two lists of matters each of which requires a different majority. First, there are ‘reserve matters’ that can only be amended by a vote of a higher percentage of bondholders (often 75% of bondholders). The list of reserve matters commonly includes financial terms of bonds, that is to say, payment-related clauses (amount, maturity, currency, etc), but has increasingly become inclusive of certain protective covenants, such as choice of law and jurisdiction agreements, immunity waivers, definition of events of defaults, and so on,⁷ which were considered too important. Then, there are matters that require a lower threshold for amendment (commonly 50% or 66⅔%), discussed below.

2.07  A typical majority action clause will stipulate that:

[A]ny modification of any provision of these Conditions may be made if approved by an Extraordinary Resolution or a Written Resolution. In these Conditions, (p. 49) ‘Extraordinary Resolution’ means a resolution passed at a meeting of Noteholders duly convened and held in accordance with the Fiscal Agency Agreement by a majority of at least:

1. (i)  in the case of a Reserved Matter, 75 per cent. of the aggregate principal amount of the outstanding Notes; or

2. (ii)  in the case of a matter other than a Reserved Matter, 66⅔ per cent. of the aggregate principal amount of the outstanding Notes which are represented at that meeting.

Any Extraordinary Resolution duly passed at any such meeting shall be binding on all the Noteholders, whether present or not and whether they voted in favour or not, and all Couponholders.⁸

2.08  In the application of a majority action clause, the bondholders will vote within the four corners of the series to which they subscribed. However, the bonds will often stipulate that the ‘Series’ comprises further issues of bonds which are later consolidated with the original issue.⁹ Issuing further bonds in this manner will dilute the voting power in the original bond issuance. The power to issue bonds and consolidate them with earlier issuances may be subject to the prohibition of collusion.¹⁰

2.09  Due to the efforts of the EU and international institutions, majority action clauses have been reinforced and may come in the form of aggregation clauses. Conventional, non-reinforced majority action clauses are inherently constrained to the four corners of individual series of bonds and do not cater for the need to restructure the whole spectrum of sovereign bond issuances in one strike. Aggregation clauses are thus designed to allow the overall majority of bondholders across a number of sovereign bond issuances to restructure all of the bonds series. Aggregation clauses require both the consent of the aggregate community of bondholders and the consent of bondholders in an individual series of bonds for the restructuring to bind the minority bondholders. To illustrate, the eurozone aggregate clause requires the overall consent of 75% of bondholders combined with the approval of 66⅔% of bondholders in any single series of bonds. EU Model CACs also provide for partial cross-series (p. 50) modification if the proposed modification was not adopted by all the bond series.¹¹

2.10  The Model EU aggregation clause provides as follows:

2.11  It may become apparent that aggregation clauses suffer from a drawback—a single bondholder may still acquire a necessary blocking minority (33⅓%+1) in a single series of bonds and thus obstruct the aggregate restructuring despite the consent of overall bondholders.¹³ With this in mind, the IMF¹⁴ and the International Capital Market Association (ICMA),¹⁵ but not the EU,¹⁶ proposed a single series aggregation clause, (p. 51) otherwise known as the enhanced aggregation clause, whereby the overall majority of bondholders across the board can amend the sovereign bonds, obviating the need to obtain the consent of individual series of bonds.¹⁷ Such aggregation clauses would put an end to the practice of holdout creditors purchasing blocking minorities (either 25%+1 or 33⅓%+1) in a single series of bonds in a move to prevent the State from successfully completing the restructuring.

2.12  Exit consents are another technique of ‘financial democracy’, pursuant to which, when the sovereign debtor restructures its debt by exchanging old bonds for new bonds, it also seeks the consent of the majority of bondholders (most commonly 50%) to amend the terms of the old bonds so as to make them less valuable or practically worthless for the holdout minority. Essentially at their exit, the majority of bondholders modifies essential protective bond covenants of the old bonds, as per the exchange offer, to the detriment of minority creditors. If the minority decides to hold out, it is bound through the operation of exit consents to lose the advantage of certain bond covenants that were removed by the majority from the old bonds. Such terms may be the listing of bonds on stock exchanges,¹⁸ waivers of immunity, cross-default clauses,¹⁹ choice of law clauses, exit covenants (seeking to prevent future restructurings),²⁰ and, in admittedly rare cases, the redemption of the bonds.²¹ It is apparent that this technique is somewhat coercive and aims at fostering ‘herding’ behaviour.²²

2.13  This mechanism is triggered in pursuance of a majority action clause that allows the majority of bondholders (often 50%) to amend the non-financial terms of bonds. Generally, exit consents are put to use in one of two cases: (i) when the bonds do not contain a majority action clause that would provide for the modification of payment-related terms, or (ii) when the sovereign debtor lacks confidence that its offer would be met by (p. 52) consent of the percentage of bondholders necessary for the modification of financial terms of the bonds (75% of bondholders) (especially so when an aggressive holdout holds 25%+1 of bonds). In such cases, exit consents incentivise potential holdout creditors to accept the new, financially less attractive bonds, almost as if the financial terms were modified through a majority action clause.

2.14  Exit consents work hand in hand with another technique that seeks to give better terms to consenting bondholders. The idea is that if the consenting bondholders are offered bonds with better protections (eg application of English law, negative pledge, cross defaults), this will leave the dissenting bondholders in a worse-off situation which will bite if the State is once again in a situation of financial distress.²³

2.15  Majority action clauses are a more preferable option for the debtors, for the exit consent technique leaves some, albeit reduced, options for a minority creditor to hold out. But, concomitantly, the threshold required for the operation of a majority action clause is generally set higher than for the exit consents.

2.16  While a significant percentage of sovereign debt (mostly domestic-law governed bonds and debt expressed in a form other than bonds) lack CACs, international sovereign bonds have seen a rapid inclusion of various CACs ever since Mexico’s debut issuance in 2003. The introduction of CACs is presumed to assuage the risk of holdout litigation by subjecting the holdouts to the will of the majority of bondholders. Quite how effective CACs are in fending off aggressive holdout litigation is a question of major concern. First, the minority creditor may block the restructuring by buying 25%+1 of bonds unless enhanced aggregation clauses have been introduced into the bonds. This was recently exemplified in the Greek 2012 restructuring where only seventeen out of thirty-six debt issuances, subject to English law, were successfully modified through the use of a majority action clause. As for the remaining debt issuances, the State was unable to persuade 75% of bondholders to restructure the debt.²⁴

2.17  The official sector rests its hopes upon the introduction of enhanced aggregation clauses as proposed by the ICMA and IMF. Yet, it will take a considerable amount of time for these clauses to extend to all sovereign (p. 53) bond issuances.²⁵ To make matters worse, the introduction of enhanced aggregation clauses is likely to drive litigious distressed debt buyers to the types of sovereign debt that lack CACs in general and aggregation clauses, in particular, including trade credits, domestic debt,²⁶ official debt, to name a few.

2.18  Second, CACs, including aggregation clauses, are not a panacea in any sense: they coordinate the restructuring of bonds issued to private creditors and do not appear in other types of sovereign debt, such as official debt and trade credits.

2.19  In spite of these limitations, majority action clauses and other CACs are the toolkit of any sovereign debt restructuring and are able to impose discipline on litigious creditors. CACs represent a major shift in the dynamics of sovereign debt renegotiations. With the inclusion of majority action clauses, the sovereign debtor is able to sway a minority of creditors once the majority of creditors, often eager to collaborate with the sovereign debtor, takes the decision to restructure the sovereign debt.

2.20  One thing that merits particular emphasis is that ever since 2003, majority action clauses became almost ubiquitous in New York and English law governed bonds²⁷ and other CACs also gained in prominence to varying degrees. With the quasi-ubiquitous introduction of majority action clauses, litigation tactics are bound to undergo significant changes that will inform the discussion in this monograph. Minority creditors are now at the constant risk of being swayed by the majority decision should the sovereign debtor, by sticks and carrots, convince the majority bondholders of the unsustainability of its debt. Following this evolution, holdout creditors are left with the following two main options of litigation:

1. (i)  bring pre-emptive litigation before the majority gets the chance to consent to the restructuring and bind the minority (addressed in Chapter 3), or

2. (ii)  challenge the outcome of sovereign debt restructuring ex post, after the majority has consented to the terms of the exchange offer (addressed in Chapter 7).

(p. 54) 2.21  The third option, of course, would be to acquire a blocking minority (often 25%+1 of bonds). Another option open to distressed debt holders is to invest in financial instruments of a State which are much less legally protective of the interests of sovereign debtors. One such category of debt instruments is the domestic debt of a sovereign. Domestic bonds are less legally fortified as they lack most of the clauses ubiquitously found in external sovereign bonds. They are often silent on the applicable law²⁸ and competent court, not to mention CACs. Furthermore, and something that may hold additional allure for initial debt investors, domestic bonds may sometimes be perceived to be safer and less prone to the risk of restructuring than external bonds. That said, restructuring of domestic bonds has been done regularly, and not just in the distant past (Russia in 1998 restructured its domestic debt but not its Eurobonds).

2.22  In addition to majority action clauses, sovereign bonds often contain so-called disenfranchisement clauses which are designed to, as the name suggests, disenfranchise (remove from calculations under majority action clauses) the votes cast by certain categories of bondholders controlled by the debtor. In other words, the votes cast by State-controlled bondholders will be ignored when deciding whether a majority action clause has been triggered.

2.23  The EU Model CACs provide:

Outstanding Bonds. In determining whether holders of the requisite principal amount of outstanding Bonds have voted in favour of a proposed modification or whether a quorum is present at any meeting of Bondholders called to vote on a proposed modification, a Bond will be deemed to be not outstanding, and may not be voted for or against a proposed modification or counted in determining whether a quorum is present, if on the record date for the proposed modification:

1. (c)  the Bond is held by the Issuer, by a department, ministry or agency of the Issuer, or by a corporation, trust or other legal entity that is controlled by the Issuer or a department, ministry or agency of the Issuer and, in the case of a Bond held by any such above-mentioned corporation, trust or other legal entity, the holder of the Bond does not have autonomy of decision, where:

   1. (i)  the holder of a Bond for these purposes is the entity legally entitled to vote the Bond for or against a proposed modification or, if different, the entity whose consent or instruction is by contract required, directly or indirectly, for the legally entitled holder to vote the Bond for or against a proposed modification;(p. 55)

   2. (ii)  a corporation, trust or other legal entity is controlled by the Issuer or by a department, ministry or agency of the Issuer if the Issuer or any department, ministry or agency of the Issuer has the power, directly or indirectly, through the ownership of voting securities or other ownership interests, by contract or otherwise, to direct the management of or elect or appoint a majority of the board of directors or other persons performing similar functions in lieu of, or in addition to, the board of directors of that legal entity; and

   3. (iii)  the holder of a Bond has autonomy of decision if, under applicable law, rules or regulations and independent of any direct or indirect obligation the holder may have in relation to the Issuer:

      1. (x)  the holder may not, directly or indirectly, take instruction from the Issuer on how to vote on a proposed modification; or

      2. (y)  the holder, in determining how to vote on a proposed modification, is required to act in accordance with an objective prudential standard, in the interest of all of its stakeholders or in the holder’s own interest; or

      3. (z)  the holder owes a fiduciary or similar duty to vote on a proposed modification in the interest of one or more persons other than a person whose holdings of Bonds (if that person then held any Bonds) would be deemed to be not outstanding under this Section 2.7.²⁹

2.24  Many sovereign bonds adopted the disenfranchisement provision as set out in the ICMA Model CACs. Thus, the bonds issued by the Republic of Philippines state:

For purposes of determining whether the required percentage of holders of the debt securities of a series has approved any amendment, modification or change to, or waiver of, the debt securities or the Fiscal Agency Agreement, or whether the required percentage of holders has delivered a notice of acceleration of the debt securities of that series, debt securities owned, directly or indirectly, by the Republic or any public sector instrumentality of the Republic will be disregarded and deemed not to be outstanding (except that in determining whether the fiscal agent shall be protected in relying upon any amendment, modification, change or waiver, or any notice from holders, only debt securities that the fiscal agent knows to be so owned shall be so disregarded).

As used in this paragraph, ‘public sector instrumentality’ means Bangko Sentral, any department, ministry or agency of the Republic or any corporation, trust, financial institution or other entity owned or controlled by the Republic or any of the foregoing, and ‘control’ means the power, directly or indirectly, through the ownership of voting securities or other ownership interests or otherwise, to direct the management of or elect or appoint a majority of the board of directors or other persons performing similar functions in lieu of, or in addition to, the board of directors of a corporation, trust, financial institution or other entity.³⁰

(p. 56) 2.25  The disenfranchisement clauses thus defined do not capture certain market players. First, they do not seem to apply to those entities which are indirectly influenced or will be affected by the lighter debt burden of the State.³¹ Second, at least on their face, they do not capture subnational entities. The mechanism of disenfranchisement is addressed in detail in Chapter 7.

2.26  A third group of CACs—majority enforcement provisions—unite the enforcement powers in the hands of a group of creditors or a trustee, and thus constrain the enforcement capacity of individual creditors. Among such clauses, prominent are collective acceleration clauses that require the approval of a certain threshold of bondholders (usually 25%) to accelerate (make the debt payable and due immediately) the principal. A typical collective acceleration clause provides that:

If any of the following events (each an ‘Event of Default’) occurs and is continuing: … then the holders of not less than 25% in the aggregate principal amount of the Notes may, by written notice to the Issuer (with a copy to the Fiscal Agent at its Specified Office), declare the Notes due and payable immediately. Notice of any such declaration shall promptly be given to all other Noteholders by the Issuer. Upon any declaration of acceleration, the principal, interest and all additional amounts payable on the Notes will become immediately due and payable on the date the Issuer receives written notice of the declaration. No delay or omission of any Noteholder shall impair any such right or remedy or constitute a waiver of any such Event of Default.³²

2.27  Failing such acceleration, the disgruntled creditor is by necessity constrained to an action for the payments missed by the sovereign debtor (up to the point, perhaps, when the cumulative defaults (failure to make interest payments when due) give rise to termination for breach). By contrast, individual acceleration clauses—rarely agreed to by the sovereign debtors—vest a single bondholder with the right to accelerate the payment of the debt.³³

2.28  The impact of an acceleration clause is often mitigated by a reverse acceleration clause which allows the majority (usually 50%) of bondholders to reverse the acceleration achieved by 25% of creditors. A typical clause provides:

If the Republic receives notice in writing from holders of at least 50 per cent. in aggregate principal amount of the outstanding Notes to the effect that the Event (p. 57) of Default or Events of Default giving rise to the above mentioned declaration of acceleration is or are cured following any such declaration, the Republic shall give notice thereof in writing to the Noteholders (with a copy to the Fiscal Agent), the Notes shall cease to be due and payable. No such rescission shall affect any other or any subsequent Event of Default or any right of any Noteholder in relation thereto.³⁴

2.29  Another contractual provision which limits the right of individual creditors to bring proceedings is the trustee mechanism. With a certain degree of oversimplification, the latter mechanism confers on the trustee the exclusive right to initiate any legal action and accelerate the sovereign debt. A common criticism of the trustee mechanism is that the trustee almost never takes action of its own initiative. However, a minimum of 25% of bondholders can typically request the trustee to bring claims against the sovereign debtor. No-action clauses—precluding individual bondholders from starting legal actions against the debtor—often go hand in hand with the trustee mechanism. Additionally, other clauses also may limit the prospects of holdout litigation: sharing clauses,³⁵ mandatory prepayment clauses, and so on.

2.30  Of course, enforcement by the trustee or individual bondholders, provided they have individual standing,³⁶ is possible only if there is an event of default. Bonds often define events of default as broadly as possible and include the following:

1. 1.  Non-Payment: Uruguay’s failure for a period of 30 consecutive days to make a payment of principal or interest when due on any debt security of that series; or

2. 2.  Breach of Other Obligations: The failure for a period of 60 days following written notice to Uruguay by the trustee or holders representing 25% of the outstanding debt securities of that series to remedy the failure by Uruguay or, where applicable, Banco Central acting on Uruguay’s behalf, to observe or perform any of the covenants or agreements provided in the debt securities of that series or the indenture (other than a non-payment default); or

3. (p. 58) 3.  Cross Default:

   • •  Uruguay fails to make a payment when due or within the applicable grace period on public foreign debt issued, or amended as to payment terms, on or after April 10, 2003 having an aggregate principal amount greater than or equal to US$60,000,000 (or its equivalent in other currencies);

   • •  Any public foreign debt of Uruguay issued, or amended as to payment terms, on or after April 10, 2003 having an aggregate principal amount greater than or equal to US$60,000,000 (or its equivalent in other currencies) is accelerated due to an event of default, unless the acceleration is rescinded or annulled; or

4. 4.  Moratorium: Uruguay or certain courts declare a general suspension of payments or a moratorium on Uruguay’s public foreign debt issued, or amended as to payment terms, on or after April 10, 2003; or

5. 5.  Validity:

   • •  The validity of the debt securities of that series is contested in certain formal proceedings by Uruguay or by any governmental entity of Uruguay that has the legal power to contest the validity of the securities;

   • •  Uruguay denies any of its obligations to the holders of that series under the debt securities or the indenture; or

   • •  A legislative or constitutional measure or a final decision by a court in Uruguay purports to render any material provision of the debt securities of that series invalid or to prevent or delay the performance of any of Uruguay’s material obligations under the securities; or

6. 6.  Failure of Authorisations: Any law, regulation or governmental authorisation necessary for Uruguay to perform its material obligations under the debt securities of that series ceases to be in full force and effect or is modified in a manner that adversely affects the rights or claims of any of the holders; or

7. 7.  Judgments: Any of several special types of judgments is levied against all or any substantial part of the assets of Uruguay in connection with a monetary judgment exceeding US$60,000,000 (or its equivalent in other currencies) and Uruguay does not adequately satisfy, bond, contest in good faith, or receive a stay of execution in respect of, such judgment within 45 days; or

8. 8.  Illegality: Any applicable law, rule or regulation is adopted which would make it unlawful for Uruguay to comply with its obligations described in ‘Additional Amounts’ above; or

9. 9.  IMF Membership: Uruguay ceases to be a member of the IMF.³⁷

(p. 59) 2.31  As an alternative to the trustee mechanism, some bonds provide for the mechanism of fiscal agent. The fiscal agent is an agent of the issuer and carries out mostly administrative tasks. Unlike a trustee, the fiscal agent certainly does not have enforcement powers.³⁸

2.32  Other miscellaneous provisions regulate the enforcement of bonds. Commonly, the pari passu clause requires equal treatment with all other unsecured and unsubordinated obligations of the sovereign debtor which is likely to extend the coverage of the clause across all the debt owed by the sovereign debtor. The meaning of the clause is addressed in Chapter 7.

2.33  Unusually, in a bond issuance of 23 December 2013 that was eventually subscribed by the Russian Federation, Ukraine covenanted to comply with a debt/GDP ratio of 60% along the following lines:

So long as the Notes remain outstanding the Issuer shall ensure that the volume of the total state debt and state guaranteed debt should not at any time exceed an amount equal to 60 per cent. of the annual nominal gross domestic product of Ukraine.³⁹

2.34  The breach of this covenant was to trigger the Events of Default clause (Art 8 of Terms and Conditions of the prospectus) and allow the 25% of bondholders to accelerate the payment of the principal under the bond and seek legal redress.⁴⁰

2.35  Lastly, collective representation clauses/creditor engagement clauses provide for the creation of a creditor committee which will represent bondholders in the negotiations with the sovereign debtor.⁴¹ There is some support for these clauses in international organisations but the clauses are looked at unfavourably by market actors.

2.36  The extent of proliferation of various CACs in sovereign bonds is hard to calculate. The frequency with which majority action clauses are included in English law governed bonds is hard to measure in view of the enormous size of the universe of sovereign bonds. Extensive research conducted by Bradley and Gulati suggests that majority action clauses, in one form or another, are almost ubiquitous in English law governed bonds, plus around half of all English law governed bonds contain collective (p. 60) acceleration clauses. By contrast, majority enforcement clauses are far from being ubiquitous in sovereign bonds and are thus incapable of assuaging all of the concerns as to aggressive creditor litigation. By 2010, less than 50% of English bonds contained reverse acceleration clauses. The trustee mechanism is also found in less than half of English bonds. As of 2010, only around 50% of sovereign bonds contained disenfranchisement provisions.⁴²

2.37  Häseler, using different methodology and covering a different period of time, provides contrasting statistics about the prevalence of CACs and trustee provisions in English law governed bonds. More than half of all English governed bonds, according to his research, do not contain majority action clauses and trustee deeds in a single series of bonds, and merely 2% of English law governed bonds include both.⁴³ Only 28% of English law governed bonds contain majority action clauses.⁴⁴ Häseler locates trustee provisions in only 24% of English law governed bonds.⁴⁵

2.38  Because of the breadth of the database of Bradley and Gulati, covering seventy-five countries and the period 1990–2010, the remainder of this monograph will rely on their empirical data.

2.39  Dispute resolution clauses take two forms—jurisdiction or arbitration agreements. For a very long time, the almost exclusive forum for resolving sovereign debt disputes was litigation in court. Jurisdiction agreements almost ubiquitously select either English or New York courts.

2.40  As of recently, arbitration agreements have started making appearance in sovereign bonds. They come in a variety of forms. They can be the exclusive forum for the resolution of disputes arising out of or in connection with the bonds⁴⁶ or, alternatively, the bonds will provide that any dispute arising out of or in connection with the bonds shall be referred to and finally resolved by arbitration but the bondholder reserves the right to initiate proceedings in the courts (either of England or New York).⁴⁷