« "Middle Class Faux"? | Main | Mick Mulvaney's South Carolina Land Shenanigans All Under Seal »

Buybacks as a Sovereign Debt Restructuring Strategy: Why the Disfavor?

posted by Mitu Gulati

The ideas in this post are drawn from work with Stephen Choi.  Errors are mine.

Last week was the first session in our International Debt Finance class, both at Duke and at NYU.  This is an exciting time to be teaching this material, given the many sovereign and quasi sovereign issuers that are struggling with over indebtedness.  Among them are Argentina, Lebanon, Venezuela, Italy (maybe) and, locally, Puerto Rico.

For day one, inspired by the provocative recent article by Julia Mahoney and Ed Kitch on the possible need to restructure the multi-trillion dollar US debt stock, we assigned both the Mahoney-Kitch (2019) piece (here) and Alexander Hamilton’s 1790 Report on Public Credit (here).

Hamilton’s Report on Public Credit is an astonishing document, since it is essentially a proposal to do a brutal debt restructuring (see here) for a new nation that, while significantly reducing the nation’s debt stock, would (hopefully) also serve as a building block for a solid reputation for this new debtor.  Somehow, it worked.  In what follows, we focus on only one aspect of Hamilton’s report: Hamilton’s views on the possibility of reducing the US debt stock--some of which was trading at pennies on the dollar--by doing a market buyback prior to the announcement of his plan.  In discussing possible strategies to reduce the public debt, he flags the possibility of doing a buyback of the debt at the current market prices.  Hamilton writes of this strategy:

Fourthly. To the purchase of the public debt at the price it shall bear in the market, while it continues below its true value. This measure, which would be, in the opinion of the Secretary [i.e., Hamilton, speaking of himself in the third person], highly dishonorable to the government, if it were to precede a provision for funding the debt, would become altogether unexceptionable, after that had been made. (emphasis added).

In other words, Hamilton says that doing a buyback before the government makes public its plan to fund the debt, would be wrong.  Why?  We don’t know exactly why.  But reading between the lines, AH would perhaps explain that the sovereign debtor should not be the beneficiary of its own misconduct (the default), particularly at the expense of its own citizens (the sellers of the paper at a discount). 

Question is, given that we have an additional 200 years plus of experience of sovereign restructurings since Hamilton, was he right to disfavor the buyback strategy? As a practical matter, in terms of the playbook of the modern sovereign debt restructurer, Hamilton’s admonition seems to have held sway. That is illustrated by this 2019 IMF publication on “How to Restructure Sovereign Debt: Lessons From Four Decades” which mentions buybacks only in a footnote (note 3, here) that suggests that prevailing economic wisdom is that they don’t work particularly well as a restructuring strategy.

The question of whether a buyback might work though has come up again though, given the deep discount at which Venezuelan sovereign and quasi sovereign debt (i.e., the debt of Petróleos de Venezuela, S.A., or PSDVA, the Venezuelan state-owned oil and natural gas company) is currently trading From what we hear from our trader friends, prices are in the range of 5-10 cents on the dollar for both Republic and PDVSA bonds, with the latter more discounted than the former.  [Alternatively, one could think of Argentine debt, where the bonds are trading in the vicinity of 40 cents on the dollar (see here) and where no creditor we know of is currently willing to vote in favor of a restructuring that imposes a 60% haircut].

Assuming for purposes of argument that the odds are that an eventual Venezuelan debt restructuring (once the current Maduro government is ejected) will have to offer creditors significantly more than 10 cents on the dollar to get their consents, why doesn’t the country simply do a buyback at this discounted price and retire the debt?  Wouldn’t that result in a level of debt relief (in the vicinity of 90%) that none of the other restructuring plans on the table could plausibly deliver?  Of course, the market may not believe that the odds are in favor of an eventual Venezuelan debt restructuring—hence why the Venezuelan debt trades at a discount.  But the Venezuelan government has better information than the market on what it intends to do.  Could the Venezuelan government cash in on this better information (in the case where the government is more likely to restructure than the market realizes) and buy back its bonds on the cheap?

Generally, when students ask the buyback question about a country whose bonds are in the toilet, our response is to turn to the conventional economics story, which is that sovereign debt buybacks are unlikely to work for the debtor.  That is so for at least three reasons beyond Hamilton’s concern about dishonor.

First, the market would see the purchases as a positive signal that the sovereign has funds and the price of the bonds would rise.  Second, the use of scarce funds to buy back and retire some of the debt will increase the price of the remaining debt (since there is now less debt to be repaid) and end up making a future restructuring more expensive. Third, the experience of the sovereign bond restructurings of the last two decades teaches that what works are exchange offers, not buybacks. (The title of the classic 1988 sovereign buyback paper by Jeremy Bulow and Kenneth Rogoff, “The Buyback Boondoggle” – where the ones getting the boondoggle are the creditors rather than the debtor).

But does the foregoing have to be the case? In the Bulow and Rogoff (1988) story, based on the Bolivian buyback experience in 1987, the market knew that the sovereign was attempting a buyback.  (A number of friendly donor countries had provided the funds).  But what if the sovereign did a secret buyback through some sympathetic financial institutions?  After all, it is not difficult to find an institution that can engineer the purchase without triggering any sort of disclosure requirements.  Nor, best we can tell from the Venezuelan debt contracts, are there any constraints there on open market buybacks, either directly or indirectly.  In our dataset of sovereign bonds that covers the type of contract provisions used in international issuances over the past three decades, we have found a handful of bond issuances with constraints on issuers doing open market buybacks during times when any of their bonds are in default (mostly from the early 1990s).  However, the current outstanding Venezuelan bonds are quite explicit in giving the issuer wide discretion in doing open market purchase.  For example, the 2011 Listing Memorandum for the 11.75% Venezuelan sovereign bonds due in 2026 says, under the topic of Redemptions and Purchases:

The Republic may at any time purchase Bonds in the open market or otherwise at any price. Bonds purchased by or on behalf of the Republic may, at the discretion of the Republic, be surrendered to the Fiscal Agent for cancellation, held or resold. (emphasis added).

So, are there precedents that suggest that the foregoing can work?  Turns out that there are, but they are not particularly well known for the simple reason that they were done on the down low.  Most recently, there was Ecuador in 2008.  Under President Correa, Ecuador first threatened to default on certain bonds on the ground that they were odious and then actually defaulted. Although it took some time, market prices for the bonds Mr. Correa was targeting as odious eventually tanked and Mr. Correa’s government, via some friendly financial institutions, supposedly bought back a large portion of the debt at fire sale prices.  Then, after the secret buyback, the story goes, Mr. Correa launched a general tender offer for the bonds at 35 cents on the dollar and naturally put the bonds he already owned into the transaction to give it the appearance of widespread support. The end result, from the perspective of achieving a debt reduction, was enormously successful. (for discussions of the dodgy Ecuadorian buyback, see this delightful piece by Felix Salmon here; see also here,here, and here).

Ecuador, however, was by no means the originator of this strategy of sending out bad news to the market, causing the value of the debt to tank, and using the savings made by not having to make interest payments to buy back the debt at a deep discount. Lee Buchheit, in a piece written in the context of the early 1990s Brady deals, “Moral Hazards and Other Delights”(here), flagged the fact that this strategy was utilized by an unnamed country in 1991.  Ross Buckley, in a more extended treatment of the topic, names that sovereign as Brazil and recounts how a number of other crisis hit sovereigns (Peru, Mexico) used versions of this technique (here; pp 679-80).

Emulating the Ecuadorian strategy of declaring a default, causing prices to tank, and then doing a secret buyback/tender offer, is not particularly honorable. Among other things, such action looks like market manipulation, which is probably illegal under the U.S. securities laws to the extent the manipulation affected trades in the U.S. capital markets.  However, neither the US Securities and Exchange Commission nor the International Monetary Fund made even the tiniest squeak about Ecuadorian misbehavior and Ecuador was able to very soon return to the markets.

But we digress.  Venezuela has no need to engage in the Ecuadorian style shenanigans to cause its bond prices to tank. The combination of Mr. Maduro’s default on the debt, continued mismanagement of the economy, and the Trump administration’s sanctions barring US persons from buying Venezuelan bonds (US persons can sell), has caused the debt prices to plummet to much lower levels than either the Ecuadorian bonds in 2008 or the Brazilian ones in 1991 fell.  Indeed, from the perspective of avoiding Hamiltonian dishonor, the Juan Guaido administration (Venezuela’s government in exile) should feel safe.  After all, Mr. Guaido was not the author of the default (responsibility for which lies squarely with Mr. Maduro).  In this scenario, Mr. Guaido would not be the beneficiary of his own misconduct. The question now is: How to engineer the secret buyback?

As we see it, this could happen in a couple of ways.  One is for Mr. Guaido to be given access to some of those frozen Venezuelan assets in the US or elsewhere for the purposes of a quiet buyback. Alternatively, maybe the purchase could be done by wealth funds or banks controlled by nations sympathetic to Mr. Guaido and committed to helping a post-Maduro Venezuela return quickly to economic prosperity.  Assuming that this could be done secretly at current prices – and experience tells us that it can be -- the resulting debt reduction would be an enormous boon to the post-Maduro Venezuelan government. 

What about other legal constraints, such as anti-insider trading laws? An issuer who repurchases its own stock while in the possession of material, non-public information pertinent to the value of the stock likely has a disclose-or-abstain from trading duty under the US securities laws (the company, after all, sits in a fiduciary relationship vis-à-vis its shareholders).  But debt is different, as a recent article by Yesha Yadav points out (here). The issuer owes no fiduciary duties to the debt holders; their rights are governed by contract and we just saw what the Venezuelan debt contracts say about open market repurchases (they can be done at “any time” and at “any price”). That means that the issuer can do its buyback with as much secrecy as it wishes, so long as it is not somehow trying to mislead the market. But, as discussed above, Mr. Guaido wouldn’t be doing any misleading. The prices are already in the toilet and the situation is ripe for a quiet buyback.

We owe a thanks to sovereign debt guru, Ugo Panizza, for multiple conversations about the economics of sovereign debt buybacks.

Comments

I don’t know that Venezuela's debt buyback would be more “dishonorable” than the 99% discount Hamilton offered to Continental holders sans-qualm. It also seems pretty clear that if Venezuela were to pursue a buyback, it would be less “dishonorable” than Ecuador’s rendition, yet, Ecuador, shenanigans and all, hardly received a slap on the wrist. If the government can execute a cheaper restructuring, that lightens the taxpayers’ burden. It may be at the expense of creditors, but creditors, unlike taxpayers, are willing parties, and they don’t have to sell. They also don’t have to lend in the future, but they will.

Like Mike, I think it’s odd to conceive of buybacks in terms of “honor.” Debt is governed by contract law, not fiduciary duty. If a leader believes it’s in the best interest of her country to retire sovereign debt through a duplicitous buyback, and it’s permitted in the indenture, she should do it. Neither institutional investors nor credit rating agencies feel bound by “honor”. Why be honest? If the market doesn’t price in a penalty on countries that secretly buyback debt, engage in this practice until the market adjusts. A leader’s duty is to the people, not Wall Street investors.

If we take "dishonorable" as buying back without disclosing the intent to do so, we would say Venezuela's possible buyback on information advantage would be dishonorable. However, at least, unlike the Ecuador case, it seems Venezuela would not resort to manipulate the prices by disseminating false information; and not violate the securities laws. But I do not take dishonorable that way. If the debtor does not have the resources to structure its debt in more favorable terms for the creditors than the buyback price, I do not see much difference between these two (negotiated structuring-buyback) in terms of being honorable given that the bonds provide Venezuela the right to buyback from the market.

I share Mike and Chuck's views on the possible inapplicability of some vague duty of "honor" with respect to sovereign bonds. As Chuck points out, bondholders have contractually consented to the terms governing their bonds, and therefore shouldn't feel wronged by an activity such as secretive sovereign buybacks so long as they [buybacks] are in accordance with those terms. However, I think there needs to be some distinction between the different types of investors involved. For example, institutional or other sophisticated investors who have the information and expertise to factor in this potentiality are in a relatively good position to protect their interests and maximize the value of their bonds, whether by anticipating such a strategy or otherwise. But what about regular people who lack such expertise and market information? They generally lack the protection of anything like US securities laws, and seem more likely to receive the short end of the stick if such a strategy is implemented. It seems to me that sovereign buybacks would accentuate this fundamental difference between sophisticated and non-sophisticated investors and result in unfair outcomes. While honor may be inapplicable, some conception of 'fairness' is key to any contractual transaction.

I don't think that if Venezuela were to use a buyback debt reduction strategy, that it would be particularly dishonorable. First, I believe that the Venezuelan government owes more of a duty to its taxpayers than the creditors. If the debt buyback would help its taxpayers while hurting creditors, I think that it is reasonable to do so given the dire economic situation in Venezuela. Second, as an oil-rich country, I don't think that a debt buyback would substantially affect creditors' willingness to lend to Venezuela in the future. While creditors would for sure be unhappy and speak a loud game, when it comes down to it, Venezuela's oil assets would basically ensure that creditors would still lend to it in favorable terms in the future out of their own self interest. Third, I agree that insider trading considerations don't apply to this particular situation because the market knows that the Venezuelan bond prices are horrible, so there would be no misleading of the market if Venezuela decided to use a debt buyback.

A covert debt buyback plan seems like a reasonable response to Venezuela’s ongoing crisis which could mitigate the holdout problems of attempting to formally restructure the debt post-Maduro. I think the concerns that a buyback plan is unfair to creditors and would harm Venezuela’s reputation in bond markets are largely irrelevant given the depth of the country’s economic crisis and current low bond prices. If creditors actually expected that Venezuela’s government was capable of and willing to honor its contractual obligations, government and PDVSA bonds would not be trading at 5-10 cents on the dollar. A buyback debt reduction plan, especially one backed by the U.S. government, could signal to future creditors that the new Venezuelan government is committed to stabilizing its economy and returning to international bond markets. The status quo—in default on an unsustainable debt burden—is more “dishonorable” to Venezuelan citizens than a debt reduction strategy that harms creditors who evidently don’t expect to be repaid in full in the near term.

The most pressing problem for Venezuela now is to stablize its economy and provide basic need for its people. If a government buyback would facilitate that process, there should not be a concern for dishonorable behavior. The concern of dishonor might be a concern for a new-born nation like the US federal government in the 18th century, it would not be Venezuela because it probably would not kill the credit market for Venezuela with parties like the EU and the US willing to lend it money with the appropriate political condition as an exchange (Maduro steps down or holds a general election, for example).

A Venezuelan buyback seems dishonorable to me. I would argue that the state succession doctrine implies that a successor regime should take some accountability for the debt-impacting actions of their predecessor. Though prices tanked under Maduro, a successor's buyback would still be Venezuela as sovereign benefitting from its own actions (uncomfortably close to what Ecuador did). Despite this, I agree with the commenters above that dishonor probably shouldn't be a driving factor in Venezuela's decision. In line with the Kitch/Mahoney article's sentiment, a successor regime should base its decisions on what harms their citizens/electoral base least. This is dependent on who holds the bonds and how quietly the buyback could be done. The last thing a fledgling regime wants is to lose favor/get ousted.

I tend to think a bit like Andres. First, it is clear that the market, correctly, is aware that Venezuelan debt is not even worth 15 cents on the dollar. If they accept to sell at current market prices, this will be confirmed. Second, Venezuela's government in exile could actually "capitalize" this buyback politically, using Venezuelan assets seized in the US to honor the country's obligations which are currently being defaulted, and prepare the path for the post-Maduro era. This would be a message to the world that the Government in exile will, as opposed to Maduro's regime, honor its obligations if and when it comes to power, thus probably obtaining enough credit at reasonable rates to rebuild the devastated economy.

The current political atmosphere suggests that Guaido is in prime position to carry out a buyback strategy. The buyback could be done by wealth funds and banks in nations sympathetic to Guaido. And luckily for Guaido, the sympathetic nations include the United States, the major EU countries, and most of Latin America. Therefore, Venezuela would neither lose access to capital markets nor be condemned by creditor nations. Further, by vastly reducing Venezuela’s debt, Guaido would be poised to rescue Venezuela from the morass that it has been dragged into by its current undemocratic regime.

Verify your Comment

Previewing your Comment

This is only a preview. Your comment has not yet been posted.

Working...
Your comment could not be posted. Error type:
Your comment has been posted. Post another comment

The letters and numbers you entered did not match the image. Please try again.

As a final step before posting your comment, enter the letters and numbers you see in the image below. This prevents automated programs from posting comments.

Having trouble reading this image? View an alternate.

Working...

Post a comment

Contributors

Current Guests

Follow Us On Twitter

Like Us on Facebook

  • Like Us on Facebook

    By "Liking" us on Facebook, you will receive excerpts of our posts in your Facebook news feed. (If you change your mind, you can undo it later.) Note that this is different than "Liking" our Facebook page, although a "Like" in either place will get you Credit Slips post on your Facebook news feed.

News Feed

Categories

Bankr-L

  • As a public service, the University of Illinois College of Law operates Bankr-L, an e-mail list on which bankruptcy professionals can exchange information. Bankr-L is administered by one of the Credit Slips bloggers, Professor Robert M. Lawless of the University of Illinois. Although Bankr-L is a free service, membership is limited only to persons with a professional connection to the bankruptcy field (e.g., lawyer, accountant, academic, judge). To request a subscription on Bankr-L, click here to visit the page for the list and then click on the link for "Subscribe." After completing the information there, please also send an e-mail to Professor Lawless (rlawless@illinois.edu) with a short description of your professional connection to bankruptcy. A link to a URL with a professional bio or other identifying information would be great.

OTHER STUFF

Powered by TypePad