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Yannis Manuelides Paper on the Limits of the "Local Law Advantage" in Eurozone Sovereign Bonds

posted by Mitu Gulati

Sovereign debt guru and Allen & Overy partner, Yannis Manuelides has a new paper (here) out on the “local law advantage” in Euro area sovereign bonds.  This paper, along with Mark Weidemaier’s paper from the beginning of the summer (here – and a prior creditslips discussion about it here), helps shed light the thorny question of which European local-law sovereign bonds should be valued more by investors: Ones with CACs or ones without them.  Given that there are billions of euros worth of these bonds with and without CACs being traded every day, one might have thought that there would be clear answers to these questions from the issuing authorities themselves.  There are not.  Further, some of the folks at the various government debt offices take the bizarre (to me) view that answering this question might somehow scare the market.

CACs or collective actions clauses – as creditslips readers know -- are provisions that enable a cram down of dissenting or holdout creditors in a restructuring via a supermajority vote (usually somewhere between 66.67% and 75%).  

The question of whether the insertion of CACs in sovereign bonds will raise or lower the sovereign’s borrowing costs has been analyzed to death in the foreign-law context (e.g., here and here).  The local-law context is potentially different though.

The fact that a bond is governed by local law means that the government always has the power to pass laws to specify the contract provisions that apply to bonds issued in the future by that sovereign.  This is the “local law advantage” (here). Question then is whether CAC and No-CAC bonds are essentially the same.  Put differently: Are CACs in local-law governed sovereign bonds utterly meaningless? The papers by Mark and Yannis show in different ways that this is not the case. 

Take the local-law governed CAC bonds first.  Here, the presence of a CAC means that the government can directly go to the investors to ask for the requisite vote needed to restructure.  This aspect is no different than the foreign-law bond context. The difference from the foreign-law bond context is that here, with the local-law CAC bonds, the sovereign can also use a variety of other techniques to restructure these bonds such as raising withholding taxes, changing the laws to make it near impossible for creditors to attach the government’s assets, giving itself heightened sovereign immunities from suit and so on and so forth. (Outside the Euro area, where the bonds would likely be denominated in the local currency, there would also be the option of inflating the currency).

The problem with those other techniques though is that every one of them comes with costs; like screwing up aspects of the domestic legal system and the likelihood of domestic litigation over the legality of such actions. The sovereign is likely to ultimately win the litigation, because it is sovereign and has to right to take these actions.  But litigation means delay and uncertainty.  The benefit of using the CAC is that there already is a mechanism that creditors agreed to when they purchased the bonds.  To paraphrase Mark’s superb paper, CACs in Euro area local-law bonds provide the sovereign with a litigation-free restructuring option. Conversely, creditors holding No-CAC bonds under local law have a litigation option that CAC bonds do not have.

Ordinarily, one might think of a litigation option as value enhancing for an investor because it is a threat to constrain the debtor from acting opportunistically in seeking an unneeded restructuring.  Here though, because a bond is a collective enterprise, investors have to weigh the benefit of deterring the sovereign debtor from opportunistic restructuring against the cost of having opportunistic fellow creditors who will use that litigation threat to try and extract rents for themselves.

With the foregoing in mind, let us consider the bonds without CACs, the No-CAC bonds. As described above, the fact that these bonds do not have CACs does not mean that they are safe from a restructuring.  A sovereign can always restructure its local-law bonds via a variety of techniques. But if there is no pre specified mechanism that the creditors agreed to at the outset, the techniques are going to bring with them litigation risk.  And that potentially means unneeded costs and delays in a world where there are specialist holdouts who use the threat of litigation to extract additional value for themselves.

The specific technique that was used by Greece in 2012 and by Barbados in 2019 for their local-law bonds is the CAC retrofit.  As Yannis explains, one hopes that sovereigns in crisis do not find themselves with a lot of No-CAC debt, but that is necessarily going to be the case in any Euro area sovereign debt restructuring in the near future (think Italy).

In such a case, the results of the dozens of creditor lawsuits challenging the Greek retrofit tells us three things.  First, that the Greek/Bajan retrofit can work and is likely the safest option in terms of minimizing litigation risk.  Second, even this relatively safe retrofit option will only work if it is implemented with care.  And third, there is nevertheless likely to be at least some creditor litigation. 

As Yannis explains by digging deep into the most important of these cases – the Mamatas and Others v. Greece case from the European Court of Human Rights (here) -- there are limits on the use of the retrofit technique.

I won’t be able to do justice to Yannis’ thorough and detailed analysis of the Mamatas case, but here are my two takeways:

First, a Euro area sovereign always has the option of using the retrofit technique when it comes to local-law bonds. Specifically, if a country like Italy has to do a restructuring in the next couple of years and finds itself with a large stock of bonds and other debt instruments lacking CACs, the existing model Euro CACs can be retrofit on to the pre-2013 issued bonds, the guaranteed bonds, and the short maturity bonds that don’t have them.  

Second, that action will be subject to court scrutiny – in domestic courts, in investment arbitration dispute resolution settings, and ultimately at the ECHR.  While what Greece did passed muster, given the deep crisis and the need for the sovereign to take remedial action, the ECHR found that it was an interference with property rights.  And for government interference with property rights to pass court scrutiny, it needs to be carefully calibrated to address the crisis at hand and be as market friendly as possible.

The Greek retrofit technique survived litigation in large part because a majority of creditors affirmatively voted both to use the technique to preempt potential holdout actions. In addition, the crisis was obviously severe and the degree of restructuring pain was calibrated on the basis of analyses by credible official sector institutions such as the IMF.  Further, creditors likely would have lost even more if a subset of them had been able to hold the restructuring hostage by refusing consent.  In other words, the government’s actions in putting in place the CAC retrofit were, carefully calibrated to tackle the crisis at hand, were part of its legitimate role as a sovereign, and were not expropriatory. 

More broadly, the lesson for any sovereign is that there will likely be litigation if this retrofit technique is used.  And that means delays and costs.

To bring things full circle. What does the foregoing mean for the difference in value between a CAC and No-CAC local law bond?  The difference boils down to the risk of sovereign opportunism versus the savings in restructuring efficiency costs.  Bonds with CACs can be restructured readily.  They already have a mechanism in place to engineer the restructuring and there is little risk of creditor litigation causing delays.  The No-CAC local-law bonds bonds can be restructured. But the technique that is the safest to use – the Greek-style retrofit – is, even if used with great care, is subject to litigation risk and potential invalidation.

What this boils down to, in the Eurozone context with countries with highly credible domestic institutions such as courts, finance ministries and central banks who might be expected to constrain their government’s thoughts of opportunistic default, should be that the CAC bonds are more valuable than No-CAC ones.  Further, to the extent one can come up with measures of individual country likelihood of opportunistic use of the CACs, the CAC v. No-CAC pricing difference should be a function of those measures.  (See here and here, for some of the empirics).

As Yannis explains in his paper, there are a number of thorny questions that remain unresolved as yet such as the precedential weight that the ECHR’s Mamatas ruling will be given in subsequent litigation in domestic courts, investment arbitrations and elsewhere.  Will the authorities provide us with answers in the near future?  Definitely not.  


I wonder if the optimism over CAC bonds has to do with the fact that there hasn't been any CAC-based restructuring since CACs were introduced in the eurozone in 2012.

CAC bonds address some of the litigation issues of non-CAC bonds, but they introduce additional issues. For one, it's unclear if ECB/national central banks can legally vote *for* a CAC restructuring under TFEU art. 123. Second, there may not be enough willing creditors to achieve a CAC restructuring (this will depend on the country's creditor composition) (we discussed some of these issues here https://ssrn.com/abstract=3371973). In addition, perhaps recent attention for single-limb CACs (e.g. here http://bruegel.org/2018/12/does-the-eurogroups-reform-of-the-esm-toolkit-represent-real-progress/) suggests stakeholders are realizing the thorny holdout issues of the current dual-limb CAC.

A successful CAC restructuring will no doubt generate less litigation, but there's a lot of uncertainty re: whether a country can successfully carry out a CAC restructuring in the first place.

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