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A New Development on the CAC v. No-CAC Question in Euro Area Sovereign Bonds

posted by Mark Weidemaier

Mitu Gulati and Mark Weidemaier

We have previously discussed how Euro area sovereign bonds with Collective Action Clauses or CACs (issued after Jan 1, 2013) and without CACs (issued prior to Jan 1, 2013) potentially differ in their vulnerability to debt restructuring. For anyone trying to draw up plans to tackle a future Euro area sovereign debt crisis (e.g., in Italy), it will be crucial to decide whether the CAC and no-CAC bonds are in fact different from a restructuring perspective. Conversely, for investors trying to predict which bonds to avoid and which to buy, the matter is equally important – and indeed, should be reflected in prices (for recent empirical papers, see here, here and here).

Last week, a research note by two Dutch researchers made its way to our desks (via reporters who found the claims intriguing). These researchers, looking into investment treaties entered into by the EU with Singapore, Canada and Vietnam, were concerned about two aspects relevant to future sovereign debt restructurings (among other things). To quote their abstract:

On the eve of the vote in the European parliament on the new investment treaty between Singapore and the European Union, SOMO publishes an analysis on the risks for managing government bonds and money flows. The analysis explains how the EU-Singapore Investment Protection Agreement (IPA) negatively impacts the policy space the EU, EU member states and Singapore have to manage financial instability and prevent financial crises.

(Note:  As per the Dutch research note, the EU-Singapore Investment Agreement has not been ratified by the EU parliamentary authorities yet). The issues of concern were:

First, the treaty seemed to include government bonds within its ambit (which is not the case in all such bilateral investment treaties).

Second, the treaty has specific vote requirements that differ from other treaties (e.g., 75% in the EU- Singapore agreement; 66.67% in the EU-Canada one) and that, if not followed, allow investors to bring treaty-based claims.

One concern raised by the report is that such treaties – perhaps inadvertently, perhaps intentionally – can make future restructurings of Euro area sovereign bonds harder by granting investors in certain countries additional rights that could enable them to block restructuring attempts.

Here are our preliminary thoughts, focusing on the EU-Singapore treaty:

The Dutch researchers are right in flagging the treaty as important to future European sovereign debt restructurings. The reason for this is that the treaty gives a claim to investors harmed by a restructuring, but not in cases of "negotiated restructuring." That term includes restructurings conducted via the treaty's voting procedure. It also includes any restructuring that satisfies the following two criteria: (1) a Euro area sovereign restructures bonds that were issued with CACs and (2) the sovereign in fact uses the CAC to accomplish the restructuring. This exception plainly follows from the broad definition of "negotiated restructuring," which also includes any restructuring or rescheduling "effected through a modification or amendment of debt instruments, as provided for under their terms, including their governing law." (E.g., Annex 4 of the EU-Singapore treaty; Provision 3 (i)). So, if a bond has a Euro CAC pre-specified, with all its bells and whistles, a restructuring accomplished via that clause is a "negotiated restructuring" that does not run afoul of the treaty. 

So far, so good. But what if the sovereign decides it does not want to use the CACs to do the restructuring? That the CAC is too constraining? For example, what if it wished to engineer the restructuring by imposing a unilateral withholding tax on payments due on the bonds? Or by redenominating the currency? (The list of Reserved Matters in the Euro CACs includes some provisions that might be interpreted to forbid such acts, but we do not think that is the only way to interpret the bonds.) If we stipulate that the CACs themselves do not prevent such restructuring techniques, then it seems to us that the treaty may contain a significant new limitation—i.e., forbidding any technique that does not use the CAC or the treaty's voting procedures. If so, this is a big deal.

But is that really the effect of the treaty? To think this through, let’s consider the effect of the treaty on the no-CAC bonds (e.g., pre-Jan 1, 2013 Euro area sovereign issuances under local law). The definition of "negotiated restructuring" is quite ambiguous. Recall that the term includes a restructuring effected "through a modification or amendment of debt instruments, as provided for under their terms, including their governing law.” No-CAC (and many CAC) bonds are issued under local law. What if, say, the sovereign changes that law to include a Greek-style retrofit CAC, with a restructuring vote requirement lower than that specified in the treaty (e.g., 50%)? That would be a relatively standard use of the “local law advantage.” The treaty does not clearly forbid such an act. Indeed, it quite literally conforms to the definition of a "negotiated restructuring." And if that’s true, then perhaps other creative uses of local law advantage—like those we mentioned earlier in connection with CAC bonds—are also allowed.

Arguably, it wouldn’t make much sense for the treaty to allow such uses of local law advantage. The argument proceeds by implication from the fact that the treaty specifies an alternative voting threshold for cases where there is no pre-specified mechanism for a "negotiated" restructuring. Perhaps the implication is that the only permissible alternative to the treaty-based voting mechanism is a similar, contract-based voting mechanism (i.e., a CAC). On the other hand, that reading seems quite narrow given the fact that the treaties also allow modifications pursuant to the contract’s “governing law.”

So: we are confused. This seems an important ambiguity. Perhaps it was intentional—a way, in effect, to kick the can down the road, since there remains a great deal of uncertainty about the extent to which Euro area governments are constrained in their ability to exploit the local law advantage. But if the treaty in fact means to allow investors to assert claims in the wake of a government’s use of its local law advantage to restructure the debt, then the Dutch researchers were right in ringing the alarm bells. Kudos to them for flagging this – Myriam Vander Stichele and Bart-Jaap Verbeek.


This seems like an interesting, if narrow, stopgap measure. I still have a question though: would the treaty apply to EU Citizens holding a bond, or does it only apply in the case of citizens of Singapour/Canada who hold EU bonds?

From what I understand, this treaty governs foreign (non-EU) creditors who own EU bonds. If this understanding is correct, then it would govern a small percentage of EU debt (based on my understanding of the percentage of debt owned domestically). However, if it applies too any series of bonds that are purchased by even one citizen of Singapour/Canada, then the treaty's alternative minimum voting requirement would apply. The latter seems like a very broad interpretation...

I wonder how this treaty would affect a potential restructuring of a country with a large proportion of domestic law-governed and domestic currency-denominated bonds mostly held by domestic investors (e.g. Italy). This treaty probably doesn't allow EU residents to take advantage over what effectively counts as a retroactive CAC provision under the treaty. And I can't imagine how domestic creditors could get a similar retroactive CAC as Singapore, Canada and Vietnam investors under the BIT. Even assuming that the BIT effectively adds CACs to pre-2013 debt, I doubt countries like Italy would be affected very much.

At the end of the day, the treaty says what it says--the drafters had to have had Greece, retrofitted CACs, and the local law advantage in the background when drafting this. If this is the case, it seems like the alternative voting threshold for the cases without a pre-specified mechanism for negotiated restructuring acts as a sort of backstop to any other actions by the sovereign.

I think Mark and Mitu are right in pointing out that this is an important issue. My reading is the following.
Annex 4(3)(i) of the EU-Singapore FTA alludes to Euro CAC restructuring (which can have a voting threshold as low as 66.67%).
Annex 4(3)(ii) seeks to limit CAC retrofits of some kind (but is more creditor-friendly with the 75% voting threshold).
I am not sure that the "including their governing law" reference in Annex 4(3)(i) has any meaning beyond reflecting that CACs are now also included in local law EA bonds (which is not the case anywhere else in the world and owed to the particularities of the euro area).
I would be very surprised if the drafters had the local law advantage in mind. Still an intelectually very interesting debate and one that some actors in the debt markets might revert to when the tough gets going.

I read "negotiated restructuring" as something the drafters intended to distinguish from shock-the-conscience scenarios, and that ambiguity reads more defensively to me than something intended to fundamentally alter the paradigm in favor of creditors.

I agree with the authors' second theory here, that this is an attempt to establish conformity among the CAC & no-CAC bonds. The ambiguous reference to "governing law" looks more like an oversight, although even if true that doesn't discount its potential significance.

Very interesting -- it seems as though the treaty deals with the potential for certain EU sovereigns to use their local law advantage, even with the potential CAC bond protection, and that they sought to reinforce the CACs by saying "even if you decide not to honor the CACs, you still have to deal with this treaty's voting requirement." Although I am not certain that the treaty drafter's had this in mind, this does seem to be the effect. But then, this could implicate the sovereigns larger restructuring, which may mean the sovereign will have to do a cost/benefit analysis to determine whether it is worth utilizing the local law advantage. If anything, it adds an additional litigation risk, and thereby cost, to any potential restructuring.

I think Isabelle hit the nail on the head. The dual tails of legal obligations seems at least facially to be a real but unintended implication. Though unlikely to have a strong effect on the decision-making process for Italian courts, it very easily could be seen as a way out for European courts to find a novel way to invalidate an Italian restructuring. Isabelle's point with respect to cost is important: to me this doesn't seem like a surefire (or even likely) obstacle. But it *is* a potential one, and the added uncertainty only makes a potential restructuring that little bit more costly.

I agree with Isabelle and Nick. Putting aside the oddity of the EU agreement raising voting requirements (and thus having the effect of making future restructurings more difficult), it is unlikely this would put an end to the restructuring if it were the final obstacle. If all parties came to the table for a restructuring, the situation will likely be worse than it is now, with significant spillover effects. It would be in everyone's interest to come to a deal. However, it does come with its risks, and the costs would need to be considered when (or how) the local law advantage would be used.

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