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How Chaotic Would an Italian Debt Restructuring Be? (Not Very)

posted by Mark Weidemaier

Mark Weidemaier & Mitu Gulati

Wolfgang Munchau’s column in the FT yesterday identifies a possible Italian debt crisis as one of the biggest worries for the Eurozone. This makes sense, given Italy’s huge debt stock (upwards of 130% of GDP), seemingly irresponsible politicians, and low growth. An Italian debt restructuring would be the biggest in history, yet it might prove necessary. Munchau highlights the economic consequences of a debt restructuring (e.g., for Italian and other European banks) and also asserts that Europe’s “legal systems are not prepared.” The general sense is that an Italian debt crisis will be a disaster.

It won’t be good, that is for sure. But if planned properly, an Italian debt restructuring can be done relatively smoothly. Why? Because Italy has an enormous “local law advantage,” combined with an enormous set of captive (aka local) holders who have been, to quote an old friend in the sovereign restructuring business, “rolling over their Italian bonds since Hadrian died.”

One might ask, Didn’t Greece have the same local law advantage and wasn’t that a chaotic restructuring? Our reply is that the source of chaos in the Greek case was the unwillingness of key institutions to acknowledge that the debt was unsustainable until very late in the process. The restructuring itself was relatively smooth (for more, see here). In any case, the restructurers this time can learn from the Greek experience. Plus, the local law advantage is significantly bigger in Italy.

Students in our joint class on sovereign debt worked intensely this semester on what an Italian debt restructuring might look like, and they have recently posted their work to ssrn.com. From our informal conversations with European colleagues and friends, we understand that lawyers at various official sector institutions take the position that they do not have the power to do the things our students suggest. But we have yet to hear convincing reasons for this position. Indeed, our impression is that these lawyers are mostly worried that they will spook investors if they publicly acknowledge having the power to restructure (on the theory that investors might take this as a sign that restructuring is likely).

As background, recall that much but not all of Italy’s debt includes the new collective action clause (CAC) mandated by treaty in the Euro Area. It remains unclear whether CAC bonds will prove harder or easier to restructure. The problem is that the CACs are deeply flawed, yet we understand that many inside the Italian Treasury and Debt Management Office take the position that they must use the CAC if they are to restructure these bonds. We think that this is not correct; one of us explains why in “Restructuring Italian Debt: Do Euro CACs Constrain or Expand the Options?

Next, our student papers: Each advocates a slightly different path, and one is exclusively about how to restructure the two NY-law bonds that Italy has outstanding. We think they are pretty cool and should be useful to whoever has to deal with the ultimate restructuring. This assumes, of course, that Italy doesn’t grow its way out of debt—a prospect that doesn’t seem likely given its history and the economic policies of its current government. Our friend Ugo Panizza has a super paper on the prospects of growth out of the debt debacle here – it is from 2015, but still very relevant).

We’ve organized our student papers under the perspective taken.

Unilateral reprofiling

Reprofiling Today for a Sustainable Tomorrow: A Unilateral Italian Debt Restructuring (Cervantes, Dodev, Ellement & Sawhney)

Buying Time: The Legal Case for Italy to Extend Maturities and its Effective Advantages and Disadvantages (Cramer, Saad & Thorpe)

Retrofitting new CACs

A Long Road To Nowhere: The Legal and Remedial Futility of Challenges to a Restricted Single-Limb CAC (Zellinger)

Single Limb Solution: Restructuring Italian Debt (Harrington, Klabo & Pita)

Using the existing CACs

Why Reinvent the Wheel? Restructuring Italy's Debt Using the Euro CAC (Buchta, Plambeck, Shan & Shufro)

New York law bonds that many thought impossible to restructure (perhaps incorrectly?)

Restructuring Italy’s New York Law Bonds (Kropp)

Comments

Unilaterally extending maturities under article 3 of its local statute would only postpone the obligation to pay the bonds, without actually restructuring the debt. In addition, there would be unpredictable reputational consequences that could affect future restructure attempt.
Therefore, the existing Euro CACs would be the best solution to consider – as these have also been implemented through a local legislative act.
The solution suggested in the article “Single-Limb Solution: Restructuring Italian Debt” seems difficult to be legally implemented since it requires that the terms in the CAC must be applied to all contracts whether issued before or after 2003.
We would thus choose the solution proposed in the article “Why Reinvent the Wheel?: Restructuring Italy's Debt Using the Euro-CAC”, because it seems to give two options to creditors hence minimizing litigation risks.
Here the CAC should be used for the post 2013-bonds allowing the creditors to choose either to (i) accept lower payment but on time or (ii) getting paid later.

The debt situation in Italy is unaffordable and can bring the euro zone together with it. In this sense, something must be done. Having said, I consider the difference between CAC and no-CAC bonds trully important here. I believe that the no-CAC bonds protect investors from restructuring, allowing veto vote from each bondholder and holdout practice, yet the no-CAC bonds don’t actually say it and being governed mostly by the local law. In such situation I think Italy government should offer principal's reduction in a first moment, followed by no maturity changes. Since it could be easily challenged by creditors unwilling to settle, for those, the principal could be maintened at the price of having the maturity expanded many and many times, based on the local law disposition that allows it. Concerning the CAC bonds, the government should try to obtain the minimum threshold to pay a reduced amount and bidding others. I think it could work depending on the actors interests

The solutions presented by the first two papers, concerning unilaterally reprofiling, would only delay the obligation of Italy to pay its debt, without actually restructuring it. This would only maintain the same situation and let the debt grow even bigger. They are based on the false presumption that Italy’s economy will start growing, which does not seem to be true.
The next two solutions, of retrofitting new CACs, advocate for the junction of the two classes of Italian debt, the ones issued before 2013 that contain no CAC and the ones issued after 2013, that include a CAC. This seems to be a fairly difficult solution to take and it will also only restructure a portion of Italy’s debt.
Therefore, the more reasonable solution would be the one presented in the paper “Why Reinvent the Wheel? Restructuring Italy’s Debt Using the Euro CAC and Maturity Extension”. It is an easiest and less risky solution as it uses the Euro CAC already incorporated in most bonds and it is also the fastest and more flexible solution as it allows the creditors to choose between two options: getting paid less but on time under mutually agreed terms or getting paid later.

With reference to the bond prior to 2013 I would suggest Italy to unilaterally amend the payment terms by extending the maturity. This would be justified by the existing local law of 2003 that allows the Minsitry of Finance to postpone the bond maturity.

For the bond issued post 2013 I would suggest Italy to restructure the debt using the EURO CAC (75%) mechanism. This would allow to either extend the maturity or agree on a haircut on principal and interest. In addition, it would probably persuade some reluctant creditors which could be subect to maturity extension anyways.

I believe it is a strong argument to say that the mere threat of a maturity extension will induce enough creditors to participate in a CAC operation. But even if it does not, Italy has the statutory authority to do so. Furthermore, considering that most of Italy’s debt is held by domestic creditors, they would likely have an interest in a successful restructuring than foreign creditors
All of the above would be based on the grounds of sustainable public finance debt management! Superior public interest would be key!

In our opinion, using the new CACs and retrofitting them, while at the same time imposing a maturity extension on debt held by non-participating creditors is the best option at hand. This is due to the following reasons:
1. The carrot (vote for restructuring and being able to vote for favorable terms) and stick (extension of maturity - may be restructured in the future too) that the proposal offers will allow Italy to persuade a critical mass of domestic creditors and comfortably meet the CAC voting threshold (locally held debt subject to the threat of a maturity extension)
2. The largest amount of debt will be addressed, so we will achieve an immediate and significant reduction of debt (approximately two-thirds of the eligible decree debt are issued with the Euro CAC;close to two-thirds of Italy’s total gross debt is owned by domestic creditors)
3. Unilaterally extending maturity just postpones the problem (plus based on the false presumption that Italy’s economy is about to jump-start.)
4. The option to retrofit new CACs would reduce just 25 % of debt and not does not address the remaining post 2013 debt

Italy issued bonds under local law and foreign law (2 bonds), which must have a different solution taking into account that they operate under different law, the latter not being analyzed below.

In relation to bonds issued under local law (with CACs or not), we question:

Do Govs must use the CACs ? If they can assure the majority, then it’s fine for them and shall use for bonds that have CAC’s. If they cant assure, must they use it? I don’t think so as the wording of EU directive is that they may resort to CACs. Therefore, Italy can proceed under local law – and this solution applies to bonds issued before 2013 with no CACs. That means changing local law? Sure, but not retroactively like the US or Greece – that creates legal uncertainty and should that be the normal modus operandi that would discredit the market and the ability of Italy issuing bonds under its local law. That solution was used and should be used in exceptional cases only. Italy can resort to other mechanisms such as unilaterally extending the maturity of the loans (as allowed under Italian law) which would already allow for more time to pay those debts. It surely wouldn’t allow Italy to change the amount being paid, imposing a reduction, but that could be already one favorable solution. Another option would be a change in law to increase of taxes on payment to bondholders to, at the end, reduce the net amount paid to those bondholders.

Also, because this way Italy would not be using CACs and no acceleration clauses would be included, that sure benefits Italy. Given the legal uncertainty of the applicability of the general regime over the bonds contracts that did not specify anything in relation to acceleration, it is deemed a risk but a justifiable one taking into account the other scenarios.

The strategy of resorting tom unilaterally extension could bring the bondholders to play to renegotiate under penalty of there being no renegotiation and Italy simply postponing the payment.

Hence, the solution above is considered the best solution - in spite of carrying risks - to prevent an holdout and of quick implementation.

To extend domestic government securities maturity seems to be presumably necessary for Italy's debt relief. I mostly agree with the views and legal interpretation presented by Cervantes, Dodev, Ellement & Sawhney and also clarified further by Cramer, Saad & Thorpe. First of all, a defensible interpretation of the model-CACs and the ESM treaty suggests its compatibility with any domestic legal framework concerned to the same issues in question. Indeed, there is a strong argument that the CACs were never meant to handcuff governments but instead provide an avenue for "private sector involvement" if such involvement was deemed "economically or politically necessary in connection with disbursement of emergency loans." Bearing that in mind, notably that the use of the CAC model in a restructuring is na option, not a requirement, and subject to the local law. Therefore follows that the 2003 Act, subject to the issue of a new framework decree (that does not require any approval by the Parliament), would allow Italy may seek for an uniform solution and unilaterally reprofile its debt.

From my point of view the most pragmatic solution and the solution which has the best success-probability, is using the existing CACs. The risk of a subsequent implementation of a maturity extension for the non complying creditors should be used to pressure enough creditors into agreeing and reaching the CACs thresholds. The possibility of maturity extension is a powerful tool but from my point of view also legally uncertain if it will uphold in litigation. This uncertainty however is also a risk for creditors and may motivate them into agreeing on a principal haircut to begin with. To start with maturity extension on the other hand could force creditors into litigation has they would not have another choice- therefore posing higher litigation risks for the Italian state and the eu. Also compared to the retrofitting of CACs this strategies limits litigation strategies and increases probabilities of a mutual agreement. Even if the necessary threshold can not be reached, this strategy does not prevent other strategies from implementation going forward.

Italy should unilaterally extend its maturities through the Consolidated Act. Most of Italy’s outstanding bonds are domestic government securities, and this Act would allow the Minister of Finance to issue a framework decree which would allow the Treasury to transform the maturities. This would also be easier to manage because the outstanding bonds would be transformed in the same way. Even though this would postpone the debt, this option has few legal risks and would likely withstand any challenges in the European Courts and could give Italy some time to fully resolve the issue. Interpreting Articles 3 and 8 of the Act suggests that Italy has the legal authority to unilaterally extend maturities. This interpretation, combined with the Italian Civil Code guidelines of looking at the intent of the parties, further suggests that such actions would withstand legal challenges.

Existing financial situation in Italy demands for an effective and fast outstanding debt restructuring.
The best way to obtain prescribed aim is to give creditors an option either to receive the payment on time but within the limited amount established under the mutual agreement by the 75 % of all creditors participating in the mentioned option or to subject their debts to the unilateral decision of the Italy’s government as under the 2003 Consolidated Act, domestic government is entitled to transform the maturity of the national and external debts. Mentioned Act provides for an opportunity to extend the maturity of the debts but also to reduce their maturity (under one year) in order to exclude the Euro CAC applicability and therefore apply another solutions and methods to restructure, e.g. retrofitting contracts by means of newly issued legal acts.
Bearing in mind that almost all of the Italy’s debts are local and only 2 issued bonds are foreign law bonds, domestic creditors are likely to have a great interest in restructuring existing debt. Therefore, mentioned method of division of creditors and their debts under their option, provides a solution to restore Italy’s debt sustainability and fast restructure at least part of the debts with an option to restructure the rest in the future under the authorization of the domestic law.

It is known that the Italian debt arises to 130% of its GDP and also that its economical growth is not sufficent to compensate the increase of its sovereign debt. Currently Italy is facing the risk of "state bankrupcy", since it might not be able to comply with the terms of its bonds with the increase of the economical risks.

In this scenario, i.e, Italy's bankrupcy would be contagious to all the Eurozone and with direct impact on all the states of the EU and other appart from it.

In order to avoid "state's bankrupcy" Italy might unilaterally extend the maturity of its bonds, in a clear exercise of sovereignity but harming its international economical credibility.

On the other hand, by implementing the Euro CAC's, reduces the risks, but it is not so imediate as extenting the maturity unilaterally.

This is why I believe that a "mixed" solution might be applicable: on one hand, extending the maturity and on the other hand, but at the same time, negotiate with the bondholders a tailormade use of the Euro CACs'.

This would allow Italy to gain some time and negotiate a solution allowing the country to comply with its international obligations.

The only viable way to me appear to be the way suggested by proposal five (Buchta et al). It is a moderate version of proposals one and two, with a supplemented negotiation-option.
Introducing an explicitly retroactive CAC runs the risk to be struck down by the domestic and European courts after the refinement of the legal framework in the aftermath of the Greek financial crisis (e.g. the introducing of the European CACs for all post-2013 bonds).

At the same time I agree with the legal analysis presented by proposals two (Cramer et al - which sees no legal conflict between Art. 3 and Art. 8 of the 2003 Domestic Law) and one (Cervantes et al - which finds the application of Art. 3 to be in accordance with the ESM-Treaty).
The crucial point clearly is the Art. 3-analysis. All the proposals in my view fall short of a profound legal analysis, not refering to jurisprudence and merely refering to codified rules. I am sceptical here, but there should be a viable way. This requires further investigation.

After carefully reading all of the article in the post, we concluded that the one that presented a better solution is the one entitled “Buying time: The Legal Case for Italy to Extend Maturities and its Effective Advantages and Disadvantages”.
This article states that the Italian debt could be unilaterally resolved by the Italian Government due to the language of the Model Collective Action Clause. The wording of the article, where it’s stated that the Italian Government “may” modify the bonds’ matters. This word is permissive, meaning the opposite of must, meaning that it would be mandatory.
That being said, this will extend will the pay deadlines which will benefit the Italian Government in the short and long term, since the State will have more time to balance it’s account and to be in a better position to pay all creditors, which makes this, from our point of view, a win/win situation.
Moreover, this not the only paper that with the view that the restructuring the Italian debt unilaterally.
According to the last paper, “Reprofiling today for a Sustainable Tomorrow: a Unilateral Italian Debt Restructuring, ”the Italian Government can extend the maturity of the bonds unilaterally without using the local law advantage.
In conclusion, this will extend will the pay deadlines which will benefit the Italian Government in the short and long term, since the State will have more time to balance it’s account and to be in a better position to pay all creditors, which makes this, from our point of view, a win/win situation.
In conclusion, we all agree that there should be a unilateral reprofiling of the Italian debt.

A combination of the Why Reinvent the Wheel and the Buying Time articles would be cool.

Pre-2013 I struggle to find solid ground which does not enable Italy to unilaterally extend the maturity of Italian bonds. In using the word “must”, the Treaty left the door open for unilateral extension of the maturity of italian bonds post 2013.

However, despite unilateral reprofiling being a legally solution/possibility, using this mechanism might not be in the Govt.’s full interest. Why? A radical everlasting extension of maturity dates will like negatively impact Italy’s future as a borrower and contaminate consumer confidence for the rest of Europe’s bond market.

Prior to resorting to this ultima ratio tool, the Govt. should engage in bargaining (more like blackmailing, bullying) and seek to restructure debt under the following terms:
1) Receive less, over the next i.e.: 3 years; or,
2) Receive the full amount, later (maybe in 2 generations time?).

In doing this, you do not have to (i) resort to violations of the rule of law through retroactive legislation; (ii) discuss whether or not the CAC is a “must” or a “may”.

Despite a huge debt, Italy is still one of the richest European countries. As a matter of fact, private creditors are ready to borrow money to the Italian Government in order to fill in the public deficit (La dette italienne retrouve les faveurs des invesitsseurs, Le Monde, janvier 2019). Italy has still a truth worthy credit on financial markets which was not the case of Greece. Italy will be able to recover thanks to European central bank under certain conditions, means as soon as Italy is willing to follow the instructions of European institutions.
Nevertheless, the first option that is to say using the Euro CACs seems the best one. The objective would be to find an agreement between the country and his creditors (La ristrutturazione del debito pubblico italiano è diventata un’opzione reale,Investireoggi, giugno 2018) . The multilateral organisms would be the one that will fix the restructuration framework in order for the private creditors to trust the country again.

In our opinion, the reasoning behind the "Why reinvent the Wheel" is the most desirable one. The grounds for this option are related to the time it would take to put into practice such idea. It might be considered aggressive since the creditors have to choose between two undesirable options: either getting payed in a lower amount or face an extension of the maturity of the contract. However, as this strategy incentivises creditors' to cooperate, by resorting to a threat, it is both the safest and the most effective. it must be noted that the threat is instrumental to get creditors to agree to restructuring. As such, the only downside of this approach would be if the threat is not enough to gather the creditor's approval to restructure the debt. Accordingly, this seems to be the least risky, fastest and easiest to implement.

Why Reinvent the Wheel?: Restructuring Italy's Debt Using the Euro-CAC

Makes the point that both mechanisms have individual advantages and that complementary application of both would likely strenghen the position of the italian Government in negotiating the restructuring of the it's debt.
None of the six options makes absurd propositions but in the comparative with the proposition of Nick Buchta, Charles Plambeck, Ashley Shan & Zachary Shufro the impacts that former projects invisioned are mitigated because of the lack of incentives for holdout creditors to agree to a restructuring plan.
Unilateral restructuring would be more exposed to litigation while the options of mutual consent is likely to be effective due to the incentive for the creditors to consent faced with the other possibilities of being subject to an extension or to not be able to collect as much money in the case that Italy is forced to pay more debt that it can sustainabilly do. It is likely that this populist italian government would rather leave the EU and Euro area before they would sell it's national assets.
Particulary to defend the extension I'd argue that either Italy will flip into prosperity and regain capacity to pay the larger debt at that prosperous moment; or Italy's finances will sink to a toxic level that would create pressure for Italy to leave the EU by catalysing friction between EU and Italy Italy would desperately want to print its own currency when it's politicians decided they believe they would not be able to flip the cycle without the mechanism of printing it's own money, a monetary easing by the ECB would increase Italy's debt instead of it's inflation. Therefore Italy would enter a situation with worse conditions of access to the debt market and poorer as it would keep accumulating the cost of interest rates; instead of just becoming poorer as the purchasing power of it's citizens would shrink.

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