The first article in this series (see International Financial Law Review, July 1998, page 17) discussed the proposal that emerging market sovereign bonds include sharing clauses to help suppress maverick litigation should a rescheduling of those bonds ever become necessary. Under the bankruptcy laws of some countries, corporate debtors that reorganize their financial affairs under the supervision of a bankruptcy tribunal are given a breathing spell from hostile creditor actions such as litigation or set-off. In the US, this is known as the automatic stay protection. Sovereign debtors do not enjoy the benefit of bankruptcy laws, their own or anyone else's, hence the proposal for replicating certain important features of a bankruptcy regime by means of contractual provisions in the underlying debt instruments. Apart from a protection against disruptive lawsuits, many bankruptcy codes also give majority creditors the power to force a few dissidents to accept a reorganization of a corporate debtor's business affairs. Without this 'cram down' feature, a small number of creditors are in a position to take advantage of the financial concessions granted to the debtor by their fellow creditors, and this can ruin the chances for any consensual work-out. Some commentators have suggested that future sovereign debt reschedulings might also be facilitated by including in sovereign bonds so-called majority action clauses that would achieve a measure of cram-down protection for the sovereign issuer and its majority creditors.
Unanimity requirement
The agreements signed by sovereign borrowers in the early 1980s to restructure loans owed to commercial banks generally required that no amendments be made to the payment terms of the restructuring agreement (ie the terms specifying the amount or timing of payments due under the agreement) without the unanimous consent of all the lending banks under the agreement. The justification was that smaller creditors might be reluctant to join an arrangement in which the larger creditors could, without the express approval of their smaller colleagues, grant additional concessions to the sovereign debtor, possibly including a forgiveness of amounts owed to all the lenders. Small or regional bank lenders worried that money centre banks, by virtue of the enormity of their exposure to the debtor countries, might too readily accept concessions to avoid a potential default. The bank advisory or steering committees that led the negotiations with sovereign debtors during the 1980s claimed that such a unanimity requirement was essential to ensure widespread acceptance of the debt reschedulings by the broader banking community.
The sovereign borrowers warned that this approach to future amendments was fraught with danger. The unanimity requirement gave every single lender — no matter how trivial its participation in the credit — the power to block any subsequent rescheduling. The need to secure unanimous approval of a further rescheduling could, the sovereign borrowers argued, at the least delay a deal and at the worst force someone (the borrower or another lender) to buy out the exposure of a hold-out bank. These warnings were generally ignored by the bank advisory committees administering the reschedulings. The committees were, at the outset of the process, supremely confident of their ability either to persuade or to bludgeon all of their fellow bankers into concurring with the collective wishes of the banking community.
The borrowers were right. The first round of debt rescheduling for a particular country may have enjoyed unanimous participation, but the second, third and fourth rounds did not. Within two years of the first rescheduling, fissures appeared in the cohesion of the banking community: big banks versus little banks; regional banks versus money centre banks; banks in North America versus banks in Europe, Japan and the Gulf; banks with large loan loss reserve provisions versus banks without such provisions. Making matters worse, by the middle of the decade the debt began to trade into the hands of non-banks, some of which were distressingly immune to the persuasive powers of bank advisory committees and bank regulators.
As the years rolled on, an increasing number of creditors balked at the prospect of seemingly endless reschedulings of their sovereign exposure. More lenders were prepared to be labelled by the advisory committees as mavericks, hold-outs, hold-ups or free riders. The period widened considerably between the dates the documentation packages for sovereign reschedulings were opened for signature and the dates the last straggler signed up. And, when cajoling and pressuring failed, the last recalcitrants were quietly bought out, given deposits or promised new business to satisfy the unanimity requirement of the amendment clauses (see International Financial Law Review, February 1991, page 11).
By the end of the 1980s, a few of the bank advisory or steering committees had come to see the wisdom of permitting future amendments to the payment terms of restructuring agreements without requiring the consent of all creditors. The last of the Brazilian deposit facility agreements (vintage 1988), for example, permitted such amendments with the approval of lenders holding 95% of amounts outstanding under that agreement. The original 1983 version required 100%. The final step in the debt restructuring process, the Brady initiative, was deliberately structured as an exchange of new bonds for existing restructured debt (rather than just an amendment of the old restructuring agreements), in part to circumvent the stranglehold of unanimous amendment clauses.
| Majority Action Clause Modifications and amendments to the Fiscal Agency Agreement or the Bonds requiring Bondholder consent may be made, and future compliance therewith or past default by the Issuer may be waived, with the consent of the Issuer and the holders of at least a majority of aggregate principal amount of the Bonds at the time outstanding, provided that no such modification, amendment or waiver of the Fiscal Agency Agreement or any Bond may, without the consent of holders of at least __% of aggregate outstanding principal amount of the Bonds voting at the bondholders' meeting convened for this purpose, (i) change the stated maturity of the principal of or interest on any such Bond; (ii) reduce the principal of or interest on any such Bond; (iii) change the currency of payment of the principal of or interest on any such Bond; or (iv) reduce the above-stated percentage of aggregate principal amounts of Bonds outstanding or reduce the quorum requirements or the percentage of voters required for the taking of any action. |
Bond practice
Majority action clauses were not carried over to the Eurobonds issued by these sovereign borrowers when the debt crisis ended. After all, the only purpose of the clause is to facilitate a future rescheduling of payments due under the instrument. Even the theoretical possibility of a rescheduling of bond debt was not something that the sovereign issuers or their underwriters were anxious to acknowledge as they set about selling the new bonds to a group of as yet unbruised investors.
In addition, the indentures or fiscal agency agreements under which bonds are issued in the international markets have been heavily influenced by the requirements of the US Trust Indenture Act of 1939. The TIA, applying to US publicly-issued bonds of corporate borrowers, expressly precludes (Section 316(b)) any reduction in the amounts due to a bondholder without that bondholder's consent or any impairment of a bondholder's right to institute suit to recover such amounts, although a vote of 75% of bondholders can defer for up to three years the due date for an interest payment.
The legislative history of the TIA indicates that the SEC was concerned that majority action clauses in public bonds could permit corporate insiders to gain control of a bond issue and then vote to forego payments on the bond to the detriment of the minority bondholders. The company's excess cash would then slosh over to the insiders in their capacity as stockholders, and this would effectively invert the normal bankruptcy priorities which require that debtholders are paid ahead of equity. If any corporate bond debt is to be forgiven, the drafters of the TIA preferred this to occur under the supervision of a bankruptcy judge to safeguard the interests of minority bondholders.
Although the rationale for this requirement of the TIA does not apply to sovereign issuers, and in any case Eurobonds and sovereign Yankee bonds do not require a TIA-qualified indenture, standard New York-law sovereign bond documentation since 1939 has generally followed the lead of the TIA in abjuring majority action clauses. Eurobonds governed by English law, even for sovereign borrowers, are sometimes more liberal: they may permit amendments to payment terms by an Extraordinary Resolution passed at a bondholders' meeting with a quorum of 75%. The presence of these provisions, if noticed at all by the original investors, does not seem to have drawn a major challenge.
The clause
The purpose of a majority action clause in a sovereign bond issue is to prevent a small number of creditors from blocking an attempt to renegotiate the terms of the bonds in the future. Viewed differently, it will ensure the disgruntled few do not have the power to force either the debtor or the other creditors to buy them out at par should a rearrangement of the debt become necessary. The question is, however, what will constitute a 'small number of creditors'?
Where majority action provisions appeared in commercial bank debt restructuring agreements at the end of the last debt crisis, the consent of a high percentage of creditors (such as 95%) was required before changes in payment terms could be made. One difficulty in using such a high percentage in a bond context is that bondholder meetings — particularly those for bearer bonds — rarely draw the attendance of all holders. The practical choices are either to specify a smaller percentage of total holders or a high percentage of holders present and voting at the meeting convened to amend the instrument (assuming a quorum has been achieved). The sample clause shown here (see box) takes the latter approach.
Market resistance to the inclusion of these clauses is likely to increase as the required percentage declines. It is not unusual, for example, to find a handful of large institutional buyers owning more than half of a Eurobond issue. The small investor may worry that the presence of a majority action clause in such an issue will only encourage the large holders to ignore the views of the smaller creditors unless the clause specifies a high percentage of affirmative votes.