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The Local Law Advantage in the Euro Area: How Much of a Constraint are the Existing CACs?

posted by Mitu Gulati

Collective Action Clauses for the Euro Area were mandated, starting in January 2013.  Yes, bizarrely, even though the introduction of Euro CACs was literally the single biggest innovation in sovereign bond contract terms in the history of this market, no one seems to have a clear idea of how these CACs (contractual restructuring mechanisms) are actually going to operate.  Specifically, if a Euro area country needs to restructure some day soon (e.g., Italy?), and it has a subset of bonds with these CACs (by next year, Italy will have something close to a super majority of its bonds with these Euro CACs), is it required to use the CACs to do the restructuring or can it use other mechanisms? That is, regardless of the presence of these CACs, can the sovereign still take advantage of the fact that almost all of its multi trillion dollar debt stock is governed by Italian local law to engineer the restructuring (the "local law advantage" in the words of sovereign debt guru Lee Buchheit - see here)?

Most people I know in the European sovereign debt world take the view that the CACs will have to be used if they are in the bonds (it is a different question altogether as to what can be done with the subset of bonds without CACs and also under local law).  And, indeed, that may be why there is currently a move to reform and improve the first-generation of Euro CACs (they appear, on their face, quite vulnerable to hold outs).  But do the Euro CACs have to be used to engineer the restructuring, if the bond that needs to be restructured has them?

As an aside, some of you may remember this question recently came up in the context of measuring redenomination risk in Euro area bonds, where because of the assumption that the bonds with CACs were protected against unilateral redenomination of the currency on the bonds by the sovereign, some were trying to use the CAC bond versus No CAC bond yield differential as a measure of redenomination risk.  (See here and here, for articles from the FT along; there are many  more) [This is not at all a crazy position, since the CAC bonds require a supermajority approval of creditors (roughly) for a change to the currency of the bond; and this is indeed the view that the market appears to have taken -- see the link/graph above from the FT - but has Mark Weidemaier demonstrated that the market was wrong in a big way?  If so, that's a big deal]

To cut to the chase, our fellow slipster, Mark Weidemaier, has a superb new paper, "Restructuring Italian (or Other Euro Area) Debt: Do Euro CACs Constrain or Expand the Options?", that suggests the foregoing thinking is misguided. Best I know, Mark's paper is the first one to address this central question about Euro CACs under local law head on (although I'm optimistic that some of our students will have good papers exploring this very question in greater depth soon).  My prediction is that there are many who will disagree strongly with Mark; particularly those who see the Euro CACs as representing some sort of holy European treaty promise.  But Mark makes a powerful argument that that view is more smoke than fire.  Euro CACs, according to him, are nothing but an option for the sovereign.  That's it, he tells us; they are nothing more. The sovereign can choose not to use this option and take an alternative (easier) route to doing its restructuring.

To quote from Mark's recently posted paper (emphasis added):

The combination of local law advantage and Euro CACs creates one of the central uncertainties affecting any restructuring of Euro Area sovereign debt. History teaches that borrower governments can easily restructure debt governed by their own laws. But this intuition co-exists with a widespread sense that Euro CACs make it harder for governments to exploit local law advantage. The reasons are often left unstated but seem driven by the view that governments must use the Euro CAC to restructure. So understood, Euro CACs are a mixed blessing. They open a new path to debt relief for a sovereign that can win the support of a bondholder majority, the size of which is defined ex ante. But they impede other paths, which a desperate (or opportunistic) sovereign might travel to ease its debt burden.

In this paper, I explain why I do not think Euro CACs have this effect. To summarize the argument: I doubt that Euro CACs materially constrain local law advantage. From the perspective of the restructurer, Euro CACs represent the safe option, not the only one. A sovereign that satisfies the Euro CAC’s voting requirements can rest easy; its restructuring will leave no holdouts and will survive almost any legal challenge. But a sovereign that has issued local-law debt remains free to alter its law to facilitate restructuring. This path involves more risk. The sovereign is constrained by its own law and institutions, by international law, and (in the Euro Area) by European law and institutions. Yet the constraints are not absolute; there is room for the prudent exercise of local law advantage. I doubt a Euro Area sovereign would eschew CACs without good reason, but the option is there.


Personally, I would be reluctant to press this permissive view of the CAC in the context of a restructuring for a couple of reasons. First, I would worry about what purchasers reasonably thought they were contracting for. The entire point of the ESM CAC was to create a stable, consistent system—creditors were supposed to know how terms were going to be altered, if they were to be altered at all. The effect of utilizing this path on the primary market for new Euro Area-bonds and the secondary market for existing CAC bonds could be severe.

Second, the total lack of precedent would create a fairly sizable litigation risk. The question of what creditors were reasonably contracting for, combined with the history and structure of the ESM Treaty, inject a ton of uncertainty to pursuing this avenue. Mark rightfully points to the sovereign's constraints (domestic and international law, European law and institutions). Each of these added layers pose an additional, potential hurdle when litigation inevitably commences.

That all said, it isn't an absurd way of reading the CAC. The litigation risk might not be as high as it seems, and I agree with Mark's analysis that if this is a permissible approach to restructuring, it would not violate the ESM Treaty's 'identical legal impact' requirement. It's an interesting way of thinking about the CACs, and it definitely warrants continued examination.

The ESM model CAC did use the word "may" instead of "must," so conceptually I agree with Mark's interpretation. But the euro CAC presents an orderly, legal, and disciplined restructuring (see Nick's first point above); non-CAC alternatives that have these features AND address the holdout problem are few and far between. Enticing individual bondholders will likely make the rest harder to restructure through CAC; other unilateral measures that take advantage of the local law-governed debt have significant litigation risks (see Nick's second point above).

I wholeheartedly agree with Nick and Ashley's comments above. However, there are two additional concerns I would have about a scenario in which a country chose *not* to rely on the euro CAC in a restructuring.

1. I do not foresee a scenario in which a country would be at the point of restructuring its debt and would seek to actively ignore a provision created by the institution that is best-situated to help alleviate its short-term financial issues (such as the ESM). As Nick says in his comment above, "[t]he entire point of the ESM CAC was to create a stable, consistent system—creditors were supposed to know how terms were going to be altered, if they were to be altered at all." The ESM, in turn, sees itself as a forum for negotiation between debtor countries and their creditors. Should a country (like Italy) ignore the euro CACs, I fear that it would be akin to them saying to the ESM "we're fine without your framework, but you should provide us with emergency funds nevertheless." This is not to say that the euro CACs are the apogee of restructuring innovations, but merely that in a case where a country decides to ignore ESM treaty provisions, I fear that the European community will be less willing to assist financially in a restructuring.

2. My second concern is far more of a big-picture issue, but couples with my first concern. The ESM Treaty, Art. 12(3), clearly lays out that a country should include CACs with an identical legal impact. To include these CACs, but then to not use them in an actual restructuring, could be read by some members of the ESM/European community as a material action contrary to the object and purpose of the ESM Treaty. Under Article 26 of the Vienna Convention on the Law of Treaties, all parties to a treaty must comply with its terms, object, and purpose in good faith. Article 60 of the same treaty clarifies that should one country act contrary to the object and purpose of a treaty, other parties are permitted to suspend obligations in whole or in part. That is to say, if members of the European community feel that a country's refusal to use CACs in a restructuring is a material action contrary to the object and purpose of the ESM Treaty, they have a legally-justifiable means of refusing to assist that country financially in a restructuring.

I agree wholeheartedly with Mark's interpretation of the CACs as not materially constraining a sovereign's local law advantage. While some of the policy concerns pointed out by Nick then echoed by Zach and Ashley are certainly worthy of consideration, the text of the CACs (and thus the contracts themselves) ought to be the most important consideration, and as Mark points out, that text is lacking any explicit constraints on local law advantage. This, combined with the evidence Mark has presented establishing that the ESM drafters of the CACs were well aware of the sovereign's powers to act under local law, both support his conclusion.

Nick's worries about determining what the parties reasonably believed they were contracting for are well taken, but I believe the existence of longstanding international-law norms and the structure of the Italian debt issues themselves provide a possible rebuttal to his contention. First, parties contracting with a sovereign power might be understood as being aware of longstanding notions of sovereign power over debt such as lex monetae, undermining the credulity of a sophisticated investor claiming that they really believed these agreements completely constrained the power of a sovereign to act according to these centuries-old tenets of international sovereign debt financing. A creditor claiming to be unsophisticated to the point of being aware of these legal tenets could hardly then turn around and claim to have relied on a thorough legal understanding of the implications of the complicated CAC contractual provisions in their bonds. Furthermore, Italy is quite explicit in its standard bearing of its powers under the Consolidated Public Debt Act (cited in Mark's paper) and a sophisticated creditor would be hard pressed to deny that he knew about the existence and implications of these powers established by legislation and vested in the Italian government when he purchased that government's debt.

If this argument is one that must fall back on policy concerns despite the strong textual and purposive evidence presented by Mark in his paper, I believe it's important to consider the most obvious goal of the ESM: Stability. While much ado has been made about the purported devastating effects unilateral sovereign action might have on Italy's credibility in the secondary markets, not as much has been said about the tremendous potential for predatory holdout creditors to derail any potential restructuring efforts under the existing CACs. If these CACs were meant to create a fair and realistic opportunity for restructuring with the goal of maintaining "stability", the restrictive nature of the dual-limb voting system means they have completely failed in that regard given the ease with which creditors can obtain blocking positions. If we are to entrust one party with maintaining "stability" in this scenario, I believe the ESM might look more favorably on a solution presented by the Italian government through unilateral action, which is at least accountable politically to its citizens, than a solution leaving these determinations in the hand of profit-oriented holdout creditors in brutal negotiations. This is especially true, if, as Mark points out at the end of his paper, a European sovereign adopts new provisions recommended by Eurozone authorities.

This paper does leave me wondering, however, about what Eurozone authorities or European sovereigns could offer creditors in future CACs. If Mark is right, and I believe he is, might European authorities consider suggesting a CAC that *does* create explicit limitations on sovereign power and the local law advantage? After all, if the markets were "wrong" about CACs providing protections against local law modifications (see the sharp increase in spread between CAC and non-CAC bonds in Italy after investors became worried about redenomination last year), creditors might well demand *actual* local law protections in the next iteration of EuroCACs. This begs the more philosophical question of whether a sovereign can divest itself of sovereign authority over local law through legislation enacted under that very same sovereign authority, but I believe an explicit contractual provision establishing a "mandatory" CAC in the future might become necessary to assuage creditor fears once Mark's thesis here is eventually shown to be correct. Is this something a sovereign would, or could, agree to?

I agree with Mark’s interpretation and also hold the view that the ESM treaty does not constrain local law advantage and bind member state to using the model-CACs in a restructuring. I somewhat disagree with a point that Nick and Zach make. While the point of CACs was indeed to “safeguard financial stability in the euro area” (to use the Commission’s own words), I believe the focus was less about consistency of investor expectations around the exact wording of CACs and more about creating consistent expectations that future restructurings would involve private sector involvement (PSI).

The ESM treaty and CACs were a response to the European sovereign debt crisis, particularly the official creditor rescue packages for Greece in 2010. CACs were meant to facilitate a new policy imperative: burden sharing through PSI. See 2010 Statement by the Eurogroup referencing PSI in adoption of the ESM treaty (noting that “[r]ules will be adapted to provide for a case by case participation of private sector creditors” and that CACs will be included “[i]n order to facilitate this process.”) https://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/118050.pdf. See also Gelpern and Gulati, The Wonder Clause. Thus, the focus was more on having a CAC/PSI involvement and less on concrete wording (other than that “CACs would be consistent with those common under UK and US law after the G10 report on CACs” (2010 Eurogroup Statement)).

While the ESM treaty was also written with the idea that restructurings should somehow be standardized across Eurozone sovereigns, nothing in the treaty’s language or construction implements the model-CACs in a way that ensures that “legal impact is identical,” or binds sovereigns to using them in a restructuring.

First, the model-CACs are “common terms of reference” on the Commission’s website – they are not law or an annex to the treaty, thereby making the language a part of the treaty. This is probably for the best, because making the model-CACs a part of the treaty would “freeze” them, requiring an amendment to the treaty if model-CACs language needed to be changed later. This mode of implementation allows the model-CACs to easily evolve over time, but it also means that the language itself is not legally binding through the treaty.

Second, the CACs are part of bonds governed by local law, making interpretation and implementation of CACs subject to local law. This entails the risk that application/interpretation of the CACs is not identical in each member state. The treaty could have mandated that CACs in local law bonds were separated from the general terms of the bonds, so that the CACs only could be governed by one commonly agreed upon law. It would likely be politically unacceptable, however, for a sovereign to submit itself to the laws of a foreign state in its domestic bond issuance.

I am not an international/treaty law expert so Zach might have a compelling argument with Art 26 of the Vienna Convention and not upholding the CACs in a restructuring contravening the object and purpose of the treaty. Given that the model-CACs are not actually part of the treaty, however, there may be some wiggle room if a sovereign implements a single limb CAC in a restructuring rather than ignoring the CACs, thus achieving the treaty’s objective of PSI through a CAC. I am tabling this last topic for future research.

I think the circumstances that gave rise to the Euro CACs are illuminating. The post-Greece controversies focused on the fact that holdouts had received overly generous treatment with respect to 1) Greek citizens subjected to harsh austerity via their government; and 2) the participating creditors.

Thus, it doesn't follow that the ESM would produce CACs to entrench positive outcomes for future prospective *holdouts*. The fear, as examined by Bucheit, et al following Greece, was that the restructuring there had succeeded in part due to its novelty. And that the experience ultimately may have signaled holding out as the preferred option for some creditors.

And yet, due to the overall success in Greece and as Mark notes, CACs emerged as a "safe" option available to a sovereign at its discretion. The treaty did not foist CACs onto unwilling sovereigns. To the point, the CACs did not apply to Italy's domestic issue until after the 2012 Ministry decree.

Indeed, as it breathed life into the CAC-inclusive bonds, that decree explicitly invoked Article 3 of the Consolidated Act, which confers the authority to transform maturities. The 2012 decree began with the declaration that the Ministry "is authorised to issue decrees that allow conducting borrowing operations defining . . . every characteristic and procedure."

Cabined within Article 3 of the Consolidated Act, then, the CACs should not be read as superimposed atop Italian law. A sophisticated creditor would know that, whatever else the CACs meant, the creditor was bargaining for CAC-inclusive bonds issued under Italy's authority to issue and define those bonds' "every characteristic and procedure."

Ultimately, inserting CACs into domestically issued bonds should only be read permissively as regarding local law. The enforceable alternative would be for the ESM and other institutions to tether relief measures to the restructuring tools — possibly including mandatory use of CACs — they deem appropriate.

I don’t agree with some of my colleagues that believe “investor expectations” were the driving concern for the ESM Treaty drafters. I think the more overarching concerns were the private sector involvement (PSI), sovereigns’ ability to effectuate an orderly restructuring, and overall economic stability throughout the Eurozone. But, due to the fact that the EuroCAC is extremely vulnerable to vulture funds sweeping in and obtaining a 1/3 blocking position in a bond series, and thereby preventing an orderly restructuring and placing the Eurozone’s economy in a precarious position, that moving away from the EuroCAC would not be going against the ESM Treaty’s “object and purpose.” In fact, I think that an action such as a retrofit CAC would be more in line with the “object and purpose” than a sovereign unilaterally taking an action.

Additionally, the Treaty does not require sovereigns to use the EuroCAC in their restructurings. Under the Vienna Convention on the law of treaties, Articles 31 declares that words should be construed based off of their “ordinary meaning.” Thus, if the EU sought to force sovereigns to use the EuroCAC in their restructurings, you’d imagine that they would put in some very strong language to force that result in accordance to their treaty interpretation cannons. But instead, ESM Treaty, Article 12 simply says CACs “shall be included” in certain bonds, and this Model EuroCAC says Reserved Matters “may” be modified through the EuroCAC.

The Treaty and Model EuroCAC drafters were under no illusion that sovereigns always use the contours of the bond to effectuate a legal restructuring––they saw Greece enact a law that applied retrofit CACs to their bonds. So, if the drafters sought to force sovereigns to use the EuroCAC in their restructurings, then they would have––in accordance to their interpretative cannons and recent history––placed stronger language than Reserved Matters “may” be modified through this CACs. Perhaps, something such as “must” be modified with the EuroCAC. I think that this type of language would be particularly important in light of the local law advantage, and in the case of Italy, the fact that its 2003 Decree grants Italy the right to unilaterally extend maturities. So in accordance with the “ordinary meaning” of the Treaty, Italy “may” modify the due date through the EuroCAC, or it “may” use its pre-existing power to unilaterally extend the maturities.

Next, Art. 12 of the ESM treaty states that CACs shall be included in a way that ensures that their “legal impact is identical.” But what does “identical legal impact” even mean? As this appears to be a hot debate among scholars, it would have been prudent for the drafters to have been more clear as to their meaning of this requirement. Additionally, Article 32 of the Vienna Convention points out when the ordinary meaning is not clear, that we can look at the circumstances surrounding the treaty to determine the meaning of ambiguous terms. As the drafters were concerned with sovereigns’ ability to restructure its debt and involve the PSI, perhaps “identical legal impact” can be more broadly interpreted than simple identical voting thresholds. But if the drafters truly sought sovereigns to institute identical voting thresholds, why would they not say something remotely along those lines? Their very interpretative cannons call for the “ordinary meaning” of words. This would have been particularly important in light of the fact that many of these bonds are governed under local law. Thus, as seen in Greece and other places such as New Jersey in Faitoute Iron v. Asbury Park (1942), sovereigns can––and do––enact laws to change the voting procedures to amend bonds.

I agree with Isabelle's comment that investor expectations were likely not the driving concern for the ESM Treaty, but I think it is important for us to actually look to what the purpose was in this discussion. Luckily, the ESM tells us. In its own words, the ESM Treaty was an action designed to “safeguard financial stability” in the Eurozone, and it aimed to increase the ability of bondholders to modify bonds containing the standardized CAC, without increasing the possibility of a government defaulting completely on its bonds. Therefore, I agree with Isabelle that moving away from the EuroCAC would not be going against the "object and purpose" if it aims to increase the ability of bondholders to modify bonds, even ones containing the standardized CAC, as long as this increases this does increase the possibility of a government defaulting completely on its bonds - which is likely the situation Italy would face if the CAC prevented it from undergoing an orderly restructuring.

I won't repeat Mark's paper, as well as Tyler, Victoria and Isabelle's comments seem to be well on point. Those analyses of the finer points of the debate ring true, and at bottom, we have to seriously ask ourselves if its plausible on any real level that a community of sovereigns would have really so dramatically limited their own rights *by implication.*

I find the discussion of investor expectations fascinating, though. Ultimately, there's been evidence that markets are pricing the CACs in a way demonstrates a level of protection, perhaps inconsistent with Mark's work. This blog has noted that: https://www.creditslips.org/creditslips/2019/02/euro-area-sovereign-bonds-cacs-or-no-cacs.html.

But then consider this PIMCO "insight" from 2012 that are much clearer about the role of the CACs moving forward that they protect bondholders from holdouts and free-riders, not sovereigns. https://www.pimco.com/en-us/insights/viewpoints/collective-action-clauses-no-panacea-for-sovereign-debt-restructurings. This is very consistent with some of the comments on this article, such as Victoria's.

This is of course anecdotal evidence, but I wonder if the PIMCO report speaks to a certain level of "drift" in how CACs have been perceived by the market. Where they were clearly seen as a level of protection- and specifically from holdouts and the costs they impose on other investors via the time and uncertainty they cause- they've been overstated as time has passed since the debates of 2012. Perhaps this error occurs cognitively because they continue to exist as an instrument on the secondary market next to non-CAC bonds that have far less holdout protection (depending on how you think about the double limbed CACs).

Ultimately, Mark's paper is sensible, and I think the CAC pricing discrepancy is more of an indictment of the market and the investment industry than his research.

Touching on Shane's point about investor expectations, there does seem to be disagreement about the difference in price between CAC and NonCAC bonds (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3318570 v. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2817041). If we go with Steffen, Grund & Schumacher's findings that CACs had limited effect on bond yields, then investor expectations should slide down our list of things to worry about.

Further, going off of Isabelle’s point about “identical legal impact,” there seems to be wiggle room there. When is impact measured? Is it when the creditors attempt to block a restructuring? Is it measuring their proportional legal rights to individual bonds versus the entire bond pool? Is it measuring a creditor’s ability to approve or disapprove of a change to a “reserved matter”? How would creditors react if a sovereign implemented a different CAC (a single-limb CAC for example), that when used in a restructuring ended up putting the creditor in a similar economic situation as the EuroCAC might have, just with a faster restructuring process? As multiple people have already noted, it is puzzling that, if the ESM meant for the EuroCAC to be the end-all/be-all, that the ESM didn’t include key language defining these key phrases.

At this point, it seems like Italy will likely get to be the guinea pig and test the boundaries of the EuroCAC for the post-2013 bonds, either by eschewing them for a local law restructuring process or by using the EuroCAC as it was meant to be used. The pre-2013 bonds are another space where Italy will get to use the lack of precedent to its advantage (or perhaps its detriment, depending on how angry the creditors get). A concurrent restructuring of the pre- and post-2013 bonds using two different CACs would be a true test, especially if several creditors hold both. It would be instructive for future restructurings to see how creditors would react.

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