Euro-Area Redenomination Risk and the Gold Clause Cases

This is a joint post by Mitu Gulati and Mark Weidemaier.

Odds seem to be against a Marine Le Pen victory in the French presidential election, though a victory by Emmanuel Macron is hardly assured. And there continues to be chatter about redenomination risk in Europe, to the point that, according to a recent Deutsche Bank estimate, even short-term German bonds were factoring in a 5% risk of redenomination. Last week, in our class on international debt finance, we discussed the so-called Gold Clause cases from the 1930s. Though ancient history in some respects, the cases offer important lessons for some of the debates regarding redenomination risk. First, though, some background.

In simplified form, the Gold Clause cases involved challenges to the Congressional abrogation of contract terms indexing a borrower's payment obligations to gold. The clauses, which appeared in both corporate and government bonds, were designed to protect against inflation. With respect to U.S. government bonds, the clauses theoretically constrained the government's ability to use monetary policy to reduce its debts. The analogy to the Euro area should be fairly clear, except that in the Euro area the constraint is structural rather than contractual: no individual government controls monetary policy. During the deflationary days of the Great Depression, the U.S. government wanted to pursue inflationary policies, but the gold clauses were a barrier that threatened to bankrupt many companies, if the not the government itself. For more detail, there are very interesting papers by Gerard Magliocca, Randall Kroszner, and Kenneth Dam. 

Long story short: The U.S. Congress passed a law abrogating these gold clauses, prompting legal challenges to the law as it applied to both corporate and government debt. The Supreme Court had a relatively easy time upholding the law as it applied to corporate debt, given the government's broad authority over the value of money. But the Court had a much harder time evaluating the abrogation of gold clauses in the government's own debt, ultimately ruling (in Perry v. United States) that the abrogation was unconstitutional. But then, in a truly bizarre bit of legal reasoning, the Court ruled that there was no remedy--indeed, no real damages--since the government had effectively banned transactions in gold.

Why is this relevant to Euro area redenomination risk? One reason is that many Euro area governments have issued bonds with contractual protections against redenomination. As we wrote a while back on FTAlphaville, these collective action clauses (CACs) require the approval of a super-majority of bondholders to change the currency of payment. But the protection CACs seemingly offer bondholders is undermined by the fact that the bonds are governed by the issuing government's law. The lesson offered by the Gold Clause cases--reaffirmed by Greece in 2012--is that bonds governed by the issuer's own law are never immune from restructuring.

Put differently: just as lenders who lend in the borrower's own currency assume currency risk, those who lend under the borrower's own law assume legal risk. Contract clauses designed to protect against the former do not protect against the latter. Notwithstanding the CACs, then, the French government could change its laws to dramatically impair the value of bonds. Conceivably this could take the form of abrogating the CACs and their protection against redenomination. But such an aggressive approach would be both unnecessary and contrary to investor expectations. Instead, the government might impair the ability of bondholders to sue for non-payment, impose a tax on payments received by bondholders, or change its laws in other ways adverse to bondholders. Even the threat of such actions might be enough to win super-majority approval of a change to the currency of payment.

We wouldn't go so far as to say that the CACs in Euro area bonds are worthless, as John Dizard seems to argue in the Financial Times. We doubt that a government would want to show such complete disregard for contract terms as to try to abrogate the CACs and then change the currency of payment by fiat. The need to negotiate with investors holding such bonds implies that the government might offer a small premium in order to win the super-majority approval necessary to change the currency of payment. Or, to put the point in terms of litigation dynamics: in lawsuits challenging any redenomination, holders of CAC bonds would have a somewhat stronger legal position than holders of non-CAC bonds, and this might translate into a slightly higher settlement value. But in a bond governed by local law, we agree that contract protections offer little value. This, more than anything else, is the lesson we take away from the Gold Clause cases.

Comments

[Maria Borges]

I do wonder, though, if what matters for contract protections to work is the governing law or the litigation strategy. In the Gold clauses case, the investors were litigating before the Supreme Court, which was being pressured by the Executive to recognize the validity of the abrogation. European bonds, however, can be litigated in external venues (ECHR, investment tribunals and even other domestic courts). When potential holdouts include the European Central Bank, litigation risk in supranational venues is certainly high. Barring extreme situations like Greece's (where drawing a parallel of the economic situation to the Great Depression is actually appropriate), I think it is unlikely that these courts would allow redenomination to jeopardize foreign creditors. So I am a little skeptical on whether threats of unilateral action would be sufficient to secure the super-majority needed for a consensual redenomination.

[Ed, Ben, Lauren, and Tres]

The Gold Clause cases provide an intriguing insight into the willingness of a country’s judiciary branch to heel to the needs of the nation when experiencing extreme financial distress. If any of the European countries with domestic law governed bonds find themselves extremely financially troubled, it does seem plausible that their respective judiciaries would follow the same line of reasoning to uphold legislation amending the terms of the bonds. While we agree that abrogating the CACs (along with the protections against redenomination) is unlikely, the reasoning in the Gold Clause cases provide the European governments with considerable bargaining power to compel a supermajority of bondholders to restructure. From our perspective, it seems as though the economic conditions in Italy make it the most likely candidate to use its “domestic law” as a hammer against creditors.

[Russell Deutsch]

If we take Perry's legal reasoning at face value, admittedly a dubious exercise, creditors incurred no damage because the government banned transactions in gold. The modern European analogue would be for France (or another Euro-area sovereign), to ban transactions in Euros. The problem is that Euros are a primary legal tender, while gold was a secondary legal tender useful (or not) for its ant-inflationary nature. In other words, in 1935, the United States could withdraw gold from circulation enforcing an abrogation of the Gold Clause, without impeding actual exchange because dollars remained available. A ban on transactions in Euros, e.g., through a forced conversion to a local currency at a fixed rate, would the real value of debt owed, but would also impose substantial transaction costs on the national economy. Further, redenomination would be complicated by the continued value of Euros elsewhere in the Euro area. The sovereign cannot truly control the exchange rate when Euros remain in circulation in accessible markets.

[Ryokichi Chigira]

Contractural rights are generally regarded to constitute property, and impairing the rights (even through legitimate exercise of sovereign power) would constitute takings, which triggers the requirement for paying just compensation. Perry's (extra legal) theory regarding the damage is doubtful from the first place, and it would be even more difficult to apply that theory to re-denomination cases. Each government does not have a power to control Euro, and are not able to prohibit exchanging its local currency with Euro or to fix the exchange rate. Developed derivative market enable us to calculate the current value of the protection for inflation risk or exchange risk (e.g., by referring to currency swap, forward exchange). It is impossible to say that there is no market for Euro and court cannot calculate the amount of the damage.

[Alix Simnock]

In response to Ryo and Russell, but what would happen if once one country leaves the Euro, other countries start to leave as well? If France (one of the stronger economies in the Euro) exits, and then perhaps Greece and then Italy, wouldn't that significantly weaken the Euro and cause other strong nations, like Germany for example, to exit as well? And if the ship is sinking, it is likely that all the others would jump ship as well and redominate, so that each country once again has control over their own currency and there is no more Euro? If this became the case, then wouldn't the scenario be more similar to Perry where there is no gold/euro available. What do others think?

Additionally, if everyone abandons the Euro, each individual country would have the ability to inflate their currencies to pay back creditors. And if the bonds are now in their own currencies, subject to their own legal regimes, rather than the Euro, there would be a lot more contractural wiggle room for individual countries to play with in their bonds. But then that raises the question of how the market would respond to that? Perhaps they would devalue the bonds? Or, particularly with the nations with stronger economics like Germany, their bonds may bounce up because they are no longer tied to the struggles of the rest of the EU?

I am also curious how this would all affect the UK? Would they be rewarded by the market and industries for being ahead of the curve?

[Andrew M]

I agree with the distinction made by Russell between gold in 1935 vs. Euros in 2017. However, I am not convinced it would matter to a French court if it were hearing one of these cases. I think the main takeaway from Perry is the court might bow to political pressure particularity if the executive vows to not adhere to the ruling and the legislature has no intention to "check" the executive. Thus, I think it might be futile to judge the merits of Perry based on the facts of the case, particularly in a foreign court without the luxury of stare decisis. In the end, I agree with Mark and recognize the risk from both borrowing from a country in their currency (particularly if they have complete monetary policy control) and/or borrowing under their law.
I am curious how the price of bonds worldwide are affected differently by 1) local law and 2) local currency? It seems to me that both are troubling although I would be more skeptical of local law. Using monetary policy to pay back bonds (at least in an extreme case i.e. more than "normal" inflation) is a foolish endeavor that I would only expect countries to use after all other options have been extinguished.

[Maxim Neumann]

Going off Mr. Deutsch’s point that it was easier to get rid of the gold clauses because gold was a secondary currency, France could do something similar in effect. For example, if France brings back the Franc, labels it the primary domestic currency and labels the Euro a secondary currency, it could phase out the use of the Euro more or less at the speed it needed. The French Central Bank could begin buying Franc denominated bonds, thereby giving the currency some support. While this transition would be far from painless, a medium of exchange, now the Franc, would be available, and a fixed conversion rate between Franc and the Euro could maintain stability.

Such a drastic move would cause a lot of damage, through transaction costs and the general chaos following a major EU signatory leaving the currency but if a country is willing to do something this drastic they have already exhausted most, if not all, of the other options. As to the other point of redenomination being complicated because of the continued use of the Euro elsewhere, the Euro would be in total crisis, with value most likely plummeting as the future of the entire EU is raised. France undoubtedly has the power to leave the Euro if it sees fit and if it chooses that route it would be a legitimate question as to what the damages are, if any, much as in Perry. The value of the Euro would be in great jeopardy and it may be that the Franc is actually worth more, erasing claims of damages.

In a situation like this, it would be important to know what kind of remedies are available outside of France and to what extent creditors can prevent France from accessing the much needed international debt markets?

[Miata Eggerly]

I echo Maria's question regarding whether it's governing law or litigation strategy that plays the primary role in ensuring contract protections work. As she notes, in the Gold Clause cases the investors were litigating before the US Supreme Court, the United States, indeed the world, was in financial disarray, and the Executive branch had stated their intent to reject any decision from the court that failed to abrogate the Gold Clauses. Given the unusual circumstances surrounding the abrogation of the Gold Clauses I am unsure how instructive Perry is in future cases. Here, European bonds can be litigated in other venues and as as Russel notes even if France were to ban transactions in Euros, the feasibility of such an act is extremely questionable. Even if other countries began a mass exodus from the Euro, I am not sure that changes the calculus.

[Sydney Booker and Miata Eggerly (who also joined me on the previous post)]

I agree with Mr. Neumann that it would certainly be possible for France, Germany, Spain or any of the other Euro nations to transition off the Euro and back to their national currency, and use monetary policy to force a re-denomination of their local-law governed bonds that may be upheld by the courts using reasoning similar to what we saw in Perry. But like Max, I believe that while this is possible, it is far from likely. As we saw in the initial handling of Greece's economic crisis, the ECB and other European institutions and leaders are extremely sensitive to investor expectations - I think that while it is dangerous to assume that Marie Le Pen would abandon her promise to move France back to the franc should she take office, I think it is safe to assume that a transition like that would be a long time in coming and would involve a lot of notice to investors to avoid destabilization. At the same time, France and Germany are not nearly as reliant on private markets to raise debt as nations like Venezuela are, which gives them a lot more leverage when contemplating a re-denomination or other form of bond restructuring.

[Khaled Fayyad]

Despite the lessons offered by the Gold Clause cases and more recently in Greece, I'm still very skeptical that European courts would apply the same rationale that would allow governments to ignore their contractual obligations to the same extent that the U.S. did in 1935 and Greece in 2012. Mark and Mitu are essentially saying, "fine, maybe CACs in Euro area bonds aren't totally worthless" because governments care about their reputation with investors and are unlikely to take unilateral action and abrogate. But, they go on to say that the value of these CACs is in the leverage they give their holders over non-CAC holders, which "translate[s] into a sightly higher settlement value." If this were the case, they still seem pretty worthless to me. But, I don't think that's the case at all! This argument takes, as a given, that creditors are more likely to opt for a small premium through negotiation than to resort to litigation. I agree with Maria that a government's threat to abrogate on CACs hardly guarantees the supermajority needed for consensual redenomination, because I think neither the creditors, nor the courts, think the factors influencing the Gold Clause decisions are relevant in this context. Contractual obligations had little, if nothing, to do with the decision in Perry. But, I won't get into that here.

[Khaled Fayyad]

Despite the lessons offered by the Gold Clause cases and more recently in Greece, I'm still very skeptical that European courts would apply the same rationale that would allow governments to ignore their contractual obligations to the same extent that the U.S. did in 1935 and Greece in 2012. Mark and Mitu are essentially saying, "fine, maybe CACs in Euro area bonds aren't totally worthless" because governments care about their reputation with investors and are unlikely to take unilateral action and abrogate. But, they go on to say that the value of these CACs is in the leverage they give their holders over non-CAC holders, which "translate[s] into a sightly higher settlement value." If this were the case, they still seem pretty worthless to me. But, I don't think that's the case at all! This argument takes, as a given, that creditors are more likely to opt for a small premium through negotiation than to resort to litigation. I agree with Maria that a government's threat to abrogate on CACs hardly guarantees the supermajority needed for consensual redenomination, because I think neither the creditors, nor the courts, think the factors influencing the Gold Clause decisions are relevant in this context. Contractual obligations had little to do with the decision in Perry. But, I won't get into that here.

[Dimitrios Lyratzakis]

Following Alix's questioning, it appears that the situation will be very different if we are talking about a unilateral exit from the Euro versus a systemic collapse of the Euro. In the latter case, we would probably see widespread re-denomination as the Euro would cease to exist as a currency; therefore even foreign law governed contracts that demand repayment in Euro will have to be re-denominated. (The distinction between unilateral exit v. Euro collapse matters because in the gold clause cases we saw unilateral de jure abrogation of payments in gold, whereas in the above scenario we see a de facto termination of payment in Euro)

We should keep in mind that re-denomination is a risk for creditors if redenomination is followed by devaluation (as in the Gold Clause cases). Devaluation risk is not uniform across countries--Greece and Italy would certainly have to devalue, but the same might not be said about stronger economies.

Maria is probably right that even if courts look at the gold clause cases or Greece as background, they will not a priori treat all the countries the same. This is another reason why the unilateral v. systemic exit/re-denomination matters: the risk of a severe GDP contraction is very different in the two cases, for each country.

Essentially I think the courts will consider whether there is unilateral re-denomination or systemic, and in each case, look at the economic consequences for the individual countries. It is not clear to me whether courts will adhere more to conceptions of necessity in the latter case than in the former, but I think the distinction matters.

[Lucas M]

Similarly to the thoughts echoed above, I’m not sure that the distinction between the gold clause cases and the redenomination risk posed here by Mr. Deutsch will matter in truth. Perry seems to stand for nothing beyond the proposition that the sovereign has the ability to change the governing law for these contracts, making it an underlying risk of any such investment. The distinction that here the Euro would continue to serve as currency and damages could be easily calculated strikes me as irrelevant given that my understanding is that the gold damages still could have been calculated – and weren’t – because it was really just pretext. The most interesting question for me is the most opaque – which outside, entirely unrelated to the law factors will influence the court’s decision. In Perry, the court acknowledged that the government was in the wrong but then decided avoiding governmental crisis was more important. Will the European court ruling on the matter have the same incentive? My thinking is that any court, regardless of whether it must tuck its’ tail between its leg as the Supreme Court did will be confronted by a similar basic principle: is it worth trying to rule against a sovereign nation in these case?