Law Commons^™

A Model-Law Approach To Restructuring Unsustainable Sovereign Debt, Steven L. Schwarcz

Faculty Scholarship

Unresolved sovereign debt problems are hurting debtor nations, their citizens and their creditors, and also can pose serious systemic threats to the international financial system. The existing contractual restructuring approach is insufficient to make sovereign debt sustainable. Although a more systematic legal resolution framework is needed, a formal multilateral approach, such as a treaty, is not currently politically viable. An informal model-law approach should be legally, politically and economically feasible. This informal approach would not require multilateral acceptance. Because most sovereign debt contracts are governed by either New York or English law, it would be sufficient if one or both …

Evaluating The 2013 Euro Cac Experiment, Elena Carletti, Paolo Colla, Mitu Gulati

Faculty Scholarship

On January 1, 2013, it became mandatory that every new sovereign bond issued by a member of the European Monetary Union include a new contract clause called a Collective Action Clause or CAC. This, we believe, constituted the biggest one-time change to the terms of sovereign debt contracts in history, impacting a market of many trillions of euros. And it was not just that the change was big in terms of the size of the market it impacted; it was big in terms of its impact on the documentation of each individual Euro area sovereign bond contract. To illustrate, prior …

A People’S History Of Collective Action Clauses, Mark C. Weidemaier, Mitu Gulati

Faculty Scholarship

For two decades, collective action clauses (CACs) have been part of the official-sector response to sovereign debt crisis, justified by claims that these clauses can help prevent bailouts and shift the burden of restructuring onto the private sector. Reform efforts in the 1990s and 2000s focused on CACs. So do efforts in the Eurozone today. CACs have even been suggested as the cure for the US municipal bond market. But bonds without CACs are still issued in major markets, so reformers feel obliged to explain why they know better. Over time, a narrative has emerged to justify pro-CAC reforms. It …

Towards A “Rule Of Law” Approach To Restructuring Sovereign Debt, Steven L. Schwarcz

Faculty Scholarship

No abstract provided.

The Gathering Storm: Restructuring Sovereign Contingent Liabilities, Lee C. Buchheit, Mitu Gulati

Faculty Scholarship

The contingent liabilities of a sovereign, such as guarantees of the debts of third parties, can normally be kept off the balance sheet of the sovereign guarantor. That is their charm. As the debt to GDP ratios of many developed countries approach red-zone levels, contingent liabilities are increasingly being favored over direct, on-the-balance-sheet, borrowings.

But what happens if a country carrying large contingent liabilities needs to restructure its debt? The borrower dare not leave its contingent claims out of the restructuring. To do so would risk undermining the financial predicates of the sovereign’s economic recovery program should the beneficiaries of …

Santa Anna And His Black Eagle: The Origins Of Pari Passu?, Benjamin Chabot, Mitu Gulati

Faculty Scholarship

One of the most debated issues in international finance is the meaning of the pari passu clause in sovereign bonds. The clause is ubiquitous; it is in almost every single foreign-law sovereign bond out there. Yet, almost no one seems to agree on its meaning. One way to cut the Gordian knot is to track down the origins of the clause. Modern lawyers may have simply copied the clause from the documents of their predecessors without understanding its meaning. But surely the people who first drafted the clause knew what it meant. Four enterprising students at Duke Law School may …

The Role Of The Imf In Future Sovereign Debt Restructurings: Report Of The Annenberg House Expert Group, Douglas G. Baird, Nicole Bollen, Lee C. Buchheit, Mitu Gulati, Anne O. Krueger, Fridrik Mar Balursson, Robert K. Rasmussen, David A. Skeel Jr., Sergei Storchak, Jeromin Settelmeyer

Faculty Scholarship

A meeting of international finance and insolvency experts was held on November 2, 2013 at the Annenberg House in Santa Monica, California. The meeting was co-hosted by the USC Law School and the Annenberg Retreat at Sunnylands. The goal was to solicit the views of experts on the implications of the IMF’s April 26, 2013 paper captioned “Sovereign Debt Restructuring -- Recent Developments and Implications for the Fund’s Legal and Policy Framework”. The April 26 paper may signal a shift in IMF policies in the area of sovereign debt workouts. Although the Expert Group discussed a number of the ideas …

The Problem Of Holdout Creditors In Eurozone Sovereign Debt Restructuring, Mitu Gulati, Lee C. Buchheit, Ignacio Tirado

Faculty Scholarship

The Eurozone official sector has declared that the belated restructuring of Greek bonds held by private sector creditors in 2012 was a “unique and exceptional” event, never, ever to be repeated in any other Eurozone country. Maybe so. But if this assurance proves in time to be as fragile as the official sector’s prior pronouncements on the subject of “private sector involvement” in Eurozone sovereign debt problems, any future Eurozone debt restructuring will be surely plagued by the problem of non-participating creditors --- holdouts. Indeed, it is the undisguised fear of holdouts and the prospect of a messy, Argentine-style debt …

The Wonder-Clause, Anna Gelpern, Mitu Gulati

Faculty Scholarship

The Greek debt crisis prompted EU officials to embark on a radical reconstruction of the European sovereign debt markets. Prominently featured in this reconstruction was a set of contract provisions called Collective Action Clauses, or CACs. CACs are supposed to help governments and private creditors to renegotiate unsustainable debt contracts, and obviate the need for EU bailouts. But European sovereign debt contacts were already amenable to restructuring; adding CACs could make it harder. Why, then, promote CACs at all, and cast them in such a central role in the market reform initiative? Using interviews with participants in the initiative and …

Collective Action Clauses For The Eurozone, Michael Bradley, Mitu Gulati

Faculty Scholarship

One of the primary policy initiatives instituted in response to the Eurozone sovereign debt crisis is a requirement that all Eurozone sovereign bonds issued after January 1 2013 include provisions referred to as Collective Action Clauses or CACs. These CACs allow for a super-majority of creditors to impose restructuring terms on minority holdouts. This article assesses the likely effect of this proposal on the borrowing costs of sovereign debtors. Contrary to much of the literature, we find that the presence of CACs leads to a lower cost of capital, especially for below-investment grade bonds

How Markets Work: The Lawyer’S Version, Mitu Gulati, W. Mark C. Weidemaier

Faculty Scholarship

In this article, we combine two sources of data to shed light on the nature of transactional legal work. The first consists of stories about contracts that circulate widely among elite transactional lawyers. Surprisingly, the stories portray lawyers as ineffective market actors who are uninterested in designing superior contracts, who follow rather than lead industry standards, and who depend on governments and other outside actors to spur innovation and correct mistakes. We juxtapose these stories against a dataset of sovereign bond contracts produced by these same lawyers. While the stories suggest that lawyers do not compete or design innovative contracts, …

Restructuring A Sovereign Debtor’S Contingent Liabilities, Mitu Gulati, Lee C. Buchheit

Faculty Scholarship

How should the contingent liabilities of a sovereign be treated in a general restructuring of the debts of that sovereign? This question has played only a minor role in past sovereign debt restructurings because the size of such contingent liabilities has in most cases been small. In recent years, however, slathering government guarantees on third party debt has become the tool of choice for many countries in their efforts to quell an incipient panic in their financial markets. Some of those sovereigns are now, or may soon be, in the position of needing to restructure their debts. Ignoring large contingent …

Revisiting Sovereign Bankruptcy, Lee C. Buchheit, Anna Gelpern, Mitu Gulati, Ugo Panizza, Beatrice Weder Di Mauro, Jeromin Zettelmeyer

Faculty Scholarship

Sovereign debt crises occur regularly and often violently. Yet there is no legally and politically recognized procedure for restructuring the debt of bankrupt sovereigns. Procedures of this type have been periodically debated, but so far been rejected, for two main reasons. First, countries have been reluctant to give up power to supranational rules or institutions, and creditors and debtors have felt that there were sufficient instruments for addressing debt crises at hoc. Second, fears that making debt easier to restructure would raise the costs and reduce the amounts of sovereign borrowing in many countries. This was perceived to be against …

The Greek Debt Restructuring: An Autopsy, Jeromin Zettelmeyer, Christoph Trebesch, Mitu Gulati

Faculty Scholarship

The Greek debt restructuring of 2012 stands out in the history of sovereign defaults. It achieved very large debt relief—over 50 percent of 2012 GDP—with minimal financial disruption, using a combination of new legal techniques, exceptionally large cash incentives, and official sector pressure on key creditors. But it did so at a cost. The timing and design of the restructuring left money on the table from the perspective of Greece, created a large risk for European taxpayers, and set precedents—particularly in its very generous treatment of holdout creditors—that are likely to make future debt restructurings in Europe more difficult.

Sovereign Debt Restructuring Options: An Analytical Comparison, Steven L. Schwarcz

Faculty Scholarship

The recent financial woes of Greece, Ireland, Portugal, and other nations have reinvigorated the debate over whether to bail out defaulting countries or, instead, restructure their debt. Bailouts are expensive, both for residents of the nation being bailed out and for parties providing the bailout funds. Because the IMF, which is subsidized by most nations (including the United States), is almost always involved in country debt bailouts, we all share the burden. Yet bailouts are virtually inevitable under the existing international framework; defaults are likely to have systemic consequences, whereas an orderly debt restructuring is currently impractical. This article analyzes …

The Evolution Of Contractual Terms In Sovereign Bonds, Stephen J. Choi, Mitu Gulati, Eric A. Posner

Faculty Scholarship

In reaction to defaults on sovereign debt contracts, issuers and creditors have strengthened the terms in sovereign debt contracts that enable creditors to enforce their debts judicially and that enable sovereigns to restructure their debts. These apparently contradictory approaches reflect attempts to solve an incomplete contracting problem in which debtors need to be forced to repay debts in good states of the world; debtors need to be granted partial relief from debt payments in bad states; debtors may attempt to exploit divisions among creditors in order to opportunistically reduce their debt burden; debtors may engage in excessively risky activities using …

Direct And Indirect U.S. Government Debt, Steven L. Schwarcz

Faculty Scholarship

No abstract provided.

Cds Zombies, Anna Gelpern, Mitu Gulati

Faculty Scholarship

This paper examines the contract interpretation strategies adopted by the International Swaps and Derivatives Association (ISDA) for its credit derivatives contracts in the Greek sovereign debt crisis. The authors argue that the economic function of sovereign credit default swaps (CDS) after Greece is limited and uncertain, partly thanks to ISDA’s insistence on textualist interpretation. Contract theory explanations for textualist preferences emphasise either transactional efficiency or relational factors, which do not fit ISDA or the derivatives market. The authors pose an alternative explanation: the embrace of textualism in this case may be a means for ISDA to reconcile the competing political …

The Dynamics Of Contract Evolution, Mitu Gulati, Stephen J. Choi, Eric A. Posner

Faculty Scholarship

Contract scholarship has given little attention to the production process for contracts. The usual assumption is that the parties will construct the contract ex nihilo, choosing all the terms so that they will maximize the surplus from the contract. In fact, parties draft most contracts by slightly modifying the terms of contracts that they have used in the past, or that other parties have used in related transactions. A small literature on boilerplate recognizes this phenomenon, but little empirical work examines the process. This Article provides an empirical analysis by drawing on a data set of sovereign bonds. The authors …

The Eurozone Debt Crisis: The Options Now, Mitu Gulati, Lee C. Bechheit

Faculty Scholarship

The Eurozone debt crisis is entering its third year. The original objective of the official sector’s response to the crisis -- containment -- has failed. All of the countries of peripheral Europe are now in play; three of them (Greece, Ireland and Portugal) operate under full official sector bailout programs.

The prospect of the crisis engulfing the larger peripheral countries, Spain and Italy, has sparked a new round of official sector containment measures. These will involve active intervention by official sector players such as the European Central Bank in order to preserve market access for the affected countries.

This article …

Drafting A Model Collective Action Clause For Eurozone Sovereign Bonds, Mitu Gulati, Lee C. Buchheit

Faculty Scholarship

In the wake of the Eurozone sovereign debt crisis, the European financial authorities announced last November that all Eurozone sovereign bonds issued after mid-2013 must contain an identical collective action clause (CAC) in order, if necessary, to facilitate a restructuring of those
instruments.

CACs in sovereign bonds have been the subject of considerable attention over the last ten years. They were introduced into sovereign bonds governed by U.S. law only in early 2003. Yet a surprising number of versions of the clause can be found in modern sovereign bonds.

The history of the research and development of this contractual provision …

Political Risk And Sovereign Debt Contracts, Mitu Gulati, Stephen J. Choi, Eric A. Posner

Faculty Scholarship

Default on sovereign debt is a form of political risk. Issuers and creditors have responded to this risk both by strengthening the terms in sovereign debt contracts that enable creditors to enforce their debts judicially and by creating terms that enable sovereigns to restructure their debts. These apparently contradictory approaches reflect attempts to solve an incomplete contracting problem in which debtors need to be forced to repay debts in good states of the world; debtors need to be granted partial relief from debt payments in bad states; debtors may attempt to exploit divisions among creditors in order to opportunistically reduce …

Pricing Terms In Sovereign Debt Contracts: A Greek Case Study With Implications For The European Crisis Resolution Mechanism, Mitu Gulati, Stephen J. Choi, Eric A. Posner

Faculty Scholarship

Conventional wisdom holds that boilerplate contract terms are ignored by parties, and thus are not priced into contracts. We test this view by comparing Greek sovereign bonds that have Greek choice-of-law terms and Greek sovereign bonds that have English choice-of-law terms. Because Greece can change the terms of Greek-law bonds unilaterally by changing Greek Law, and cannot change the terms of English-law bonds, Greek-law bonds should be riskier, with higher yields and lower prices. The spread between the two types of bonds should increase when the probability of Greek default increases. Recent events allow us to test this hypothesis, and …

A Minimalist Approach To State ‘Bankruptcy’, Steven L. Schwarcz

Faculty Scholarship

Increasingly finding themselves in financial straitjackets, states have been turning to austerity measures, tax increases, privatization of services, and renegotiation of collective bargaining agreements. Absent a federal government bailout, however, states will also need debt relief if their debt burden becomes so crushing that reasonable efforts at fiscal reform will fail to avoid default. Some advocate providing this relief by, effectively, extending municipal bankruptcy law to states. That approach brings in excess baggage, however, engendering political opposition and constitutional concerns. There is a simpler solution: Enable states to work out their debt problems with their creditors. Although the main obstacle …

The Market Reaction To Legal Shocks And Their Antidotes: Lessons From The Sovereign Debt Market, Michael Bradley, James D. Cox, Mitu Gulati

Faculty Scholarship

In October 2000 a hedge fund holding an unpaid debt claim won an enormous victory against the debtor, the Republic of Peru, through an opportunistic interpretation of the common pari passu clause by a Brussels court. This development was met by charges from policy makers and practitioners that the court's decision (its novel interpretation of the pari passu clause) would lead to a dramatic increase in the risks of holdout litigation faced by sovereign debtors. Over the ensuing years, multiple reform solutions were proposed including the revision of certain contractual terms, the filing of amicus briefs in a key case, …

Facing The Debt Challenge Of Countries That Are Too Big To Fail, Steven L. Schwarcz

Faculty Scholarship

The recent financial woes of Greece and other nations are reinvigorating the debate over whether to bail out defaulting countries or, instead, restructure their debt. Bailouts are expensive, in the case of Greece costing potentially hundreds of billions of euros. But a bailout was virtually inevitable because a default on Greek debt was believed to have the potential to bring down the world financial system. This is a growing problem: as finance becomes more intertwined, the potential for a countrys debt default to trigger a larger systemic collapse becomes even more tightly linked. This reveals a phenomenon viewed until recently …

How To Restructure Greek Debt, Mitu Gulati, Lee C. Buchheit

Faculty Scholarship

Plan A for addressing the Greek debt crisis has taken the form of a €110 billion financial support package for Greece announced by the European Union and the International Monetary Fund on May 2, 2010. A significant part of that €110 billion, if and when it is disbursed, will be used to repay maturing Greek debt obligations, in full and on time. The success of Plan A is not inevitable; among other things, it will require the Greeks to accept - and to stick to - a harsh fiscal adjustment program for several years. If Plan A does not prosper, …

Innovation After The Revolution: Foreign Sovereign Bond Contracts Since 2003, Mitu Gulati, Anna Gelpern

Faculty Scholarship

For over a decade, contracts literature has focused on standardization. Scholars asked how terms become standard, and why they change so rarely. This line of inquiry painted a world where a standard term persists until it is dislodged by another standard term, perhaps after a brief window of ferment before the second term takes hold. It also overshadowed the early insights of boilerplate theories, which described contracts as a mix of standard and customized terms, and asked why the mix might be suboptimal. This article brings the focus back to the mix. It examines the development of selected provisions in …

Feel-Good Formalism, Mitu Gulati, Anna Gelpern

Faculty Scholarship

This essay highlights a phenomenon that has no place in the conventional theory of sophisticated business contracts: the term that makes no sense as an enforceable promise, one that defies functional explanation, one that drafters blush to rationalize in retrospect or chalk up to honest mistake. The subset of contract drafters who stop and think about the term before the contract is signed know that it has little enforcement or other instrumental value. Even if a court were to enforce such a term, its interpretation would be extremely hard to predict at signing. Nevertheless, such clauses get included in contracts …

The Coroner’S Inquest: Ecuador’S Default And Sovereign Bond Documentation, Mitu Gulati, Lee C. Buchheit

Faculty Scholarship

Conventional wisdom is that sovereigns will rarely, if ever, default on their external debts in circumstances where it is clear that they have the capacity to pay. The first line of defense against the errant sovereign is its concern about reputation. It may have to tap the external debt markets again in the future; and there is the fear that the markets will extract revenge. But reputational constraints do not always work because some governments heavily discount future costs in favor of current benefits. When reputational constraints fail, however, a second line of defense is supposed to come into play. …