Private Ordering in Sovereign Debt Restructuring: Reforming the London Club

by Christian Kirchner* and David Ehmke**

(2012) Oxford U Comparative L Forum 3 at | How to cite this article

1. Introduction

Sovereign bonds are no longer a safe haven for investors.*** Essentially, sovereign bonds are the sovereign’s promise to pay out interest on principal lent by the bondholders and to repay the principal at maturity. Investors’ confidence in sovereign debtors keeping their promise is declining. Many sovereign debtors are facing heavy problems financing budget deficits by issuing bonds on the international capital markets. Financial distress on the part of private debtors can be dealt with via private contractual arrangements or bankruptcy procedures, whereas there are no insolvency procedures for default on sovereign debt. The idea of developing similar private arrangements (private ordering) or of creating an international bankruptcy law for sovereign debtors (public ordering) is very attractive. But attempts to design debt restructuring mechanisms for sovereign states similar to those for private debtors have not been successful.1 Private ordering in sovereign debt restructuring has played a role in the past, and the so-called London Club has played a prominent role in such cases (3.1, 3.2). But today, financial markets are much more complex. Workable solutions for debt restructuring via private ordering have to reflect that complexity. We propose to reform the procedures of the London Club to better cope with the problems of sovereign debt in international financial markets of today. Such reforms may be needed for debt restructuring within the European Economic and Monetary Union (Euro Zone). But they should also be applicable on an international level. Sovereign financial distress is not a problem confined to the Euro Zone.

2. Methodological Issues

In order to discuss a proposed change of rules – i.e. a normative endeavour – it is necessary to first engage in a positive analysis and introduce a set of assumptions. The following considerations will be based on the methodological approach of New Institutional Economics.2 This sub-branch of economics focuses on the rules of the game in the form of institutions3, i.e. general rules together with the mechanism of enforcing them. Both the rules and the mechanisms may be formal or informal.4 If institutions are being changed this should have an impact on the addressees of the rules. In order to predict their reactions, institutional economics has to work with a set of assumptions that partly derive from neo-classical economics: scarcity of resources, methodological individualism, and self-interested rational behaviour. But there are modifications: the assumption of full rationality is replaced by that of bounded rationality5, which is then complemented by the assumption of opportunistic behaviour.6 Behavioural economics has been criticizing the rationality assumption and has produced new insights into how actors behave in different situations and settings,7 further clarifying the scope of ‘bounded rationality’. Institutional economics particularly stresses that information is systematically incomplete.8

3. Proposal for the Development of the London Club

3.1 The London Club in its Contemporary Structure

In the second half of the 20th century, commercial bank loans became increasingly important for sovereign debtors who had previously financed their budgets with loans provided by other states.9 In reaction to this change, the Bank Advisory Committee – also known as the ‘London Club’ – was founded as an informal forum for negotiation. Unlike the Paris Club,10 the London Club has neither a fixed venue for negotiations nor a permanent office.11 The committee is formed ad hoc12 and the members may differ from case to case. They can represent a specific region or a specific set of claims against the debtor.13 Together with the debtor, the committee works out a restructuring plan, which is recommended to the creditors, who then decide whether to accept or reject it.14 The IMF is involved in the negotiation process as a liaison between the London and Paris Clubs; it also evaluates the sustainability of the sovereign debtor’s debt burden.15

3.2 Change of the Creditors Structure

The London Club was frequently used during the Latin American sovereign debt crisis in the 1980s. The imminent default of some Latin American sovereign debtors particularly affected the largest creditor banks in the United States. If the sovereign debtors had halted interest payments, many creditors would have been forced to declare insolvency, since the regulatory system of the United States required a loan to be listed as ‘nonperforming loan’, if interest was not paid 90 days after the due date.16 Thus the strategy was to gain time. The debtor received fresh money to pay interest while the creditor banks tried to get rid of their bad loans.17 Due to the principle of equal treatment the financial regulatory administration and the largest commercial banks exerted pressure on non-participating creditor banks.18 In order to avoid the risk of constantly granting new loans to debtors who obviously reached an unsustainable debt level, the creditor banks sold their claims on the secondary market with a discount reflecting the probability of default.19 The conversion of bank loans into bonds as a part of the Brady Plan20 accelerated this process.21

This process as well as the attraction of bonds having a higher marketability because they are relatively easy listed and traded on stock exchange markets has led to an essentially different structure of creditors, who are now more diverse and larger in number. Nowadays, apart from the enormous bond purchases in recent months by the ECB, the largest share of outstanding claims against sovereign debtors is in the hands of private creditors.22 These private creditors are smaller and larger commercial banks, investment funds, hedge funds, pension and vulture funds, insurance companies, business enterprises, and private persons doing their business primarily locally or as repeat players on the international capital markets with different repayment periods and different interest rates.23 This has led to anonymity and heterogeneity of information status among the creditors, their concerns, and their behaviour. Hedge and vulture funds especially have continuously been blamed by European politicians for having caused the sovereign debt crisis in Europe and are therefore the target of regulatory efforts. Hedge funds are legally constructed to coordinate various investments. By contrast, vulture funds are specialised on investments in the debt of weak debtors. We consider the popular blame to be a diversionary manoeuvre – blaming a scapegoat instead of recognising the alarming signals of market price decrease of sovereign bonds and escaping the Ponzi scheme of indebtedness.

The increasing market for credit derivatives has also had an important impact on creditors’ behaviour. Derivatives’ value and due date depend on a specific reference object (e.g. a bond).24 The most common derivative in sovereign debt markets is the so-called credit default swap (CDS).25 Under the standardized conditions from the International Swaps and Derivatives Association (ISDA) and their interpretation as adopted by the courts, CDSs become due if the sovereign debtor defaults or the creditor is legally bound to a restructuring plan, e.g. through collective action clauses (CAC) (3.8). A free approval of an exchange offer by the debtor caused by factual pressure does not lead to maturity.26 As a result, creditors holding CDSs have a significant incentive not to participate in a negotiation. Their incentive is instead to cause or to contribute to the default of the sovereign debtor. Since the CDS insures the purchase price, creditors may behave destructively in order to receive the higher insurance payment in the form of the purchase price.

3.3 Objective: Win-Win Situation

Our working assumption is that the chances for an effective debt restructuring of private creditors’ claims will be improved by reforms of the London Club if a model can be developed that creates a win-win-situation for both creditors and debtors. The creditors aim to reach a satisfaction quota as high as possible and to prevent defaults in future credit arrangements with the debtor. The debtor aims at reorganising and restructuring his current debt, maintaining access or re-entering international capital markets, getting fresh money and paying the lowest interest rate possible. In this respect, both parties are trying either to avoid or to minimize transaction costs.

The restructuring mechanism of the London Club itself produces transaction costs in form of information and negotiation costs.27 These costs are justified if they pay off as an investment in a club good – a good that is excludable and non-rival to outsiders but non-excludable and rival to insiders of the club. This would be the case if the London Club is able to promote creditors’ and debtors’ interests, reduce transaction costs, and accelerate the process. The anticipated costs of the restructuring process in the London Club will be evaluated by the parties in comparison to the anticipated costs of the current situation. They will be calculated ex ante.

3.4 Entitlements and Execution

Since the Sovereign Immunities Act of 1976 in the U.S., the State Immunity Act 1978 in the United Kingdom,28 and the legal distinction between acta iuri imperii and acta iurii gestioni,29 creditors can secure a title to their claim on the basis of a private bond or loan contract. There are many legal and factual obstacles to the execution of this title over domestic or external assets,30 and attempts to do so rarely succeed. Creditors therefore generally try to hamper the reorganisation and restructuring process and block the debtor’s access to international capital markets.31 This behaviour is intended to create incentives for the debtor to satisfy the free-riding creditors.

3.5 Economic Challenges on Creditors’ Side

The changing nature of creditors and the spread of credit derivatives have influenced creditors’ information status, their concerns, and thus their behaviour. Their underlying motivation remains unchanged: the increase of their individual economic advantage. If the creditors neither fear an imminent default, which could force them to file for bankruptcy, nor aspire to better relationships to the debtor, their interest dictates pressing for a satisfaction quota as high as possible.32 In order to achieve this goal, it is necessary to overcome some obstacles: anonymity and heterogeneity cause collective action problems. It becomes harder for the debtor to estimate the reaction to his restructuring offer.33 The creditors have to be identified to coordinate their actions in the negotiations.34 Incomplete information can lead to a rush to the exit, panic sales, and cancellations.35

Some creditors expect a better position as free riders or holdouts if they try to enforce their claims in court and execute against the debtor’s assets,36 to trade their claims on the secondary market, or to withhold cooperation.37 Especially for smaller creditors, the holdout tactic may be the only effective chance to give prominence to their concerns. The fear of the first-mover disadvantage causes holdout behaviour. Creditors that tend to cooperate in principle will probably tend not to cooperate if they calculate that other creditors will benefit from their concessions later on.38 CDSs create incentives to hold out, and the result is expensive delay.39 Holdouts and free riders can block the debtors’ access to international capital markets, disrupting the negotiations (3.4).40 For the debtor, it becomes more attractive to satisfy the creditors’ claims to prevent the costs that are caused by them.41

A moral hazard problem comes into play if creditors can benefit from a risky investment without carrying the losses in case the risks are realized.42 Risky investments become more attractive.43 In the expectation of a bailout, creditors tend to hold out – a behaviour that is destructive for collective interests. Therefore the probability of a bailout needs to be reduced.

3.6 Economic Challenges on Debtor’s Side

The information relationship between debtor and creditors is asymmetric. The debtor may withhold disclosure of relevant information about his economic situation and level of debts (ex-ante opportunism)44 so he can choose to default without need, unwilling to pay his debt.45 He can discriminate between different creditors and offer preferential satisfaction to creditors that provide fresh money46 or with whom he intends to strengthen his (economic or political) relationship. He might exploit the referendum if he can influence it through bonds under his control, directly or indirectly giving him the voting power to accept his own restructuring offer.47 Moral hazard is caused by a sovereign debt restructuring mechanism that is too debtor-friendly.48 On the other hand, a bailout could be used to delay the date fixed for payment into the next legislative period. Additionally, the debtor may choose to strategically breach the restructuring contract to renegotiate better conditions.

3.7 Proposed Structure and Instruments for the London Club

3.7.1 The Release

In private bankruptcies, there are different mechanisms in domestic bankruptcy laws to restrict the debtors’ opportunities to dispose of his assets and to forestall creditors’ actions against the debtor’s assets by means of a stay or moratorium. Sovereign debt restructuring through the London club does not affect the sovereignty of the sovereign, so it cannot impose exchange controls49 or a stay.50 Hence, we recommend a release by a vote of a qualified majority to strengthen the incentive for the debtor to meet his contractual obligations. This also has the advantage of bringing to light whether the debt level is unsustainable. The fear that a release would release information that could damage the debtors’ creditworthiness is unfounded. Such information can easily circulate without the mechanism we recommend. The mechanism should be able to be terminated by a qualified majority if it is deemed to be no longer needed. A release should also be possible upon the debtor’s request. To prevent a misuse of the mechanism upon an opportunistic appeal by the debtor, a qualified majority should be empowered to reject the appeal.51

3.7.2 A Representative Creditor Committee

The principle of representation should be retained in order to secure an effective negotiation forum.52 Presumably, the number of representatives will increase. The representative creditor committee’s task will be to represent and inform the creditor group constantly about the negotiation progress. Its mandate would be bound by the instructions of the creditor group it represents. Finally, the creditors will vote on the plan proposed by the representative committee.53

3.7.3 Formation of Groups

The complexity of negotiations in the London Club due to the heterogeneity of interests (3.2, 3.4, 3.5) requires the formation of creditor groups representing a nearly homogeneous group of creditors. Criteria may be the regional origin, the basis and amount of their claims, the type of creditor, or similar factors. The formation of groups has the advantage of supporting communication within the group, facilitating representation through a single representative who exclusively supports the interests of one nearly homogeneous group of creditors.

Debtors could potentially exploit the group-formation process for tactical reasons,54 so the creditors themselves should be entrusted with this task. If the mechanism is activated, they should be asked to organize themselves in groups. The goal should not be the identity of interests within the group, but rather relative homogeneity of interests, so that creditor groups can agree on a common direction for negotiations in a timely manner. Because the creditors would have to register their claims to vote,55 the trustee (2.3.4) will have acquired the information needed to coordinate and assist the formation of the creditor groups. The number of representatives should reflect the amount of claims. Whenever the owner of the claims changes, the Club should be duly informed in order to guarantee adequate representation, which is particularly in the new owner’s interest.

3.7.4 Trustee

To minimise collective action problems stemming from asymmetric information and unorganized communication among creditors and between the creditors and the debtor, the bond or loan contract should mandate the appointment of a trustee.56 He should operate independently from the mechanism, but he could serve as a neutral mediator in the negotiations. His task should be to inform all creditors constantly about the economic situation of the debtor and whether the debtor is meeting its obligations. He has to be empowered to represent the rights of all creditors in court.57 His mandate would not be focused on creditor concerns, but instead on the fulfilment of the legal obligations of the debtor towards the creditors. Other concerns (e.g. to trigger a default for a pay-out from the CDS) should not be taken into account. We do not recommend the fiscal agent in New York law nor the creditor representative in German law as a model for the trustee: the fiscal agent acts as a paying agent on behalf of the debtor (and not the creditors), for whom he performs certain payment obligations. Nor does the fiscal agent act on behalf of creditors’ interests, meaning he cannot be entitled to represent the creditors in court.58 The creditor representative in German law, who can be entitled to legally represent the creditor’s concerns, is not subject to appropriate restrictions concerning the relationship to the debtor. This is problematic in particular because of the option to restrict the creditor representative’s liability.59 However, we consider the trustee60 in New York law and the bond trustee61 in English law to be a suitable model for sovereign bonds. Both have to meet essential prerequisites ensuring their performance on behalf of the creditor’s concerns and avoid any conflicts of interests, and both are subject to sanctions like liability provisions e.g. under the New York Trust Indenture Act or the UK Trustee Act.

Although the creditors would be free to appoint a new trustee, the debtor should be given the first opportunity to nominate one. To prevent a rush to the courthouse (2.4),62 the right to accelerate as well as all procedural rights should be concentrated and delegated to the trustee through an acceleration clause63 and a clause restricting any individual legal enforcement.64 Should the trustee fail to heed the vote of a qualified minority, the restrictions should be suspended.65 To maintain these restrictions, a pro rata clause has to be inserted in the bond or loan contracts. Consequently, if a free rider receives any payment from the debtor, the trustee will be required to demand this payment pro rata to the part outstanding debt in proportion to the amount of the free rider’s claim against the debtor.

3.7.5 Permanent Institutions

Permanent institutions promise certain advantages such as the prevention of delays through a well-prepared release of negotiations66 and the reduction of transaction costs through the assistance of a permanent administration.67 To keep costs to a minimum, it would be advisable to work with minimal permanent staffing and increase the number of staff ad hoc in times of crisis. Although creditors and debtors will have an urgent interest in using the mechanism during a crisis, the permanent costs have to be defrayed by a basic charge that becomes due when the bond or loan contract is concluded. For those creditors and debtors who have not paid the basic charge, the London Club would invoice an extra charge for using its service in times of crisis.

A secretariat would maintain contact with the trustees. Once the mechanism was activated, the secretariat would ask the creditors to register their claims. The register should show the (juridical) person of the creditor, the amount of his claim, and his voting power.68 The secretariat’s being responsible for the organisational tasks would assist the formation of the creditor groups. Following the vote upon the plan, the secretariat should observe the fulfilment of the debtor’s obligations and inform the creditors about any infringements.

The representative committee’s task would be to inform and represent the creditor groups, to coordinate with the IMF and the Paris Club,69 and to negotiate the plan with the debtor.

Often, an imminent default inhibits the deployment of fresh money.70 Fresh money may be a prerequisite for a high satisfaction quota, e.g. for infrastructural investment and economic growth.71 A qualified majority in the representative committee should thus be empowered to give those creditors who provide fresh money after the start of the mechanism a preferable status for their claims based on credits in critical phases.72

3.7.6 The Offer of Jurisdiction by an Arbitral Tribunal73

While the national courts of the debtor have an incentive to decide patriotically or might at least give rise to the appearance of doing so, an arbitral tribunal located in the London Club promises to be independent. If decisions of the tribunal become legally binding when accepted ex ante in the contractual terms of the bond or loan,74 this may be the best guarantee of independence. The offer of jurisdiction is then a service offered in the free market. The judges would be free of bias, with no incentive to decide in favour of the debtor or the creditors. Otherwise the debtor will back off from implying the clauses which empower the tribunal in his bond or loan contracts because he fears higher credit costs if the tribunal is known to be too debtor-friendly or because he fears adverse decisions in conflict if the creditor is too creditor-friendly. The arbitral tribunal has to adjudicate conflicts between the creditors and between the creditors and the debtor concerning the negotiation procedure and the restructuring plan.75 Also, the competence of the tribunal determined in the contractual terms could be to decide upon the claim both as to its existence and its amount.76 A so-called vis attractiva concursus77 would avoid the legal uncertainty caused by free rider’s forum shopping78 in different jurisdictions.

3.7.7 The Restructuring Plan Obligations

The restructuring plan is the final outcome of the negotiation and will be subject to the creditors’ vote. If the plan is accepted by a qualified majority (e.g. by creditors holding two thirds or 75 per cent of the outstanding debts, the common voting levels in English bond contracts), it becomes legally binding. The Plan includes the creditors’ concessions, e.g. a reduction of the notional amount of the interest rates, the prolongation of the loan period,79 or the provision of fresh capital. In addition, the plan includes obligations of the creditor to secure the reduced amount of debts such as securities or a reorganisation plan with specific measures like an austerity or infrastructural program. The creditors win a relative security that the reduced debts will be serviced, and the debtor profits from his ability to maintain access to or to re-enter the international capital markets and relatively low credit costs80. Renewal of Original Claims

If the debtor does not meet his obligations as set out in the plan, sanctions would follow to create an incentive to comply. In this case, original claims would be renewed at the original amount.81 The renewal of claims is connected with high costs for the debtor and the creditors (e.g. costs of a delay and renegotiation, rising credit costs). Accordingly, both parties have an interest in reaching an agreement on a plan with a sufficient reduction of the debt burden. The restitution of the original claim could be ascertained by the tribunal upon request of a qualified majority. If 75 per cent is the qualified majority to vote on the plan, giving it a legally binding status, it is logical to empower the qualified minority of 25 per cent to call for renewal should the debtors breach the contract, as this minority is able to obstruct the renegotiation. Equal Treatment of Creditors

The principle of equal treatment (par conditio creditorum) aims at avoiding discrimination against particular creditors. There have been proposals to suspend this principle in sovereign debt restructuring, e.g. not to restructure the debt of private small investors.82 We also promote a suspension of the principle par conditio creditorum in sovereign debt restructuring for the following reasons: to achieve a win-win situation, transaction costs of negotiation have to be minimized to avoid a costly delay. One may object that a suspension of the equal treatment principle could prevent those creditors who feel discriminated against from consenting or providing further loans. But we have to consider expectations beyond just purely contractual obligations and the satisfaction quota as gainful relationships which can be improved through additional concessions and which can be realized as an economic gain only by some creditors.83 Other creditors may accept a higher reduction of their claim for political reasons. Yet other creditors – especially smaller ones – insist on a higher satisfaction quota and hold out because this seems to be their only opportunity to uphold their interests.84 We do not promote the possibility of different satisfaction quotas in the normative approach to treating like cases alike and different cases differently, and are not arguing that only some creditors are worthy of protection. The suspension of the principle of equal treatment offers the chance to disentangle the complex situation of diverse creditor types with heterogeneous and partly divergent interests that often leads to an impasse. To offer some creditors a higher satisfaction quota can facilitate the negotiation process, shorten a delay, and reduce transaction costs,85 so even those creditors with a lower satisfaction quota can profit from a relatively better outcome.

The formation of creditor classes, which may be different from the creditor groups outlined above, could be a solution with benefits for all creditors. Unequal treatment and the formation of creditor classes solely based on the decision of the sovereign debtor would be worst because it would give way to uncontrolled opportunistic behaviour, and consequently to substantial negative external effects. The formation of creditor classes should thus be based on a vote of the creditors. The double qualified majority rule would apply, requiring approval by creditors holding 75 per cent of the outstanding debts and by the creditors holding 50 per cent of outstanding debts within the specific creditor classes. The arbitral tribunal may be empowered to oversee the formation and to decide upon the question of whether the formation of groups has sufficient basis in fact. To restrict the incentives for project-jeopardizing arbitrage, the trading of bonds and loans on the secondary market from one creditor class to another to profit from difference in price, the creditors should fix a date from which assignment operates retroactively.

3.8 Collective Action Clauses

3.8.1 CAC in Sovereign Bonds / Loan Contracts

Collective action clauses (CAC) are an essential prerequisite for successful negotiations in order to prestructure the negotiation process. CACs, unlike unanimous action clauses (UAC), allow for a qualified vote upon payment terms and provide the contracting parties with the legal power to bind non-cooperating parties.86 CACs are commonly included in bonds issued under English law and approved by that jurisdiction. By contrast, CACs were not implied into bonds issued in New York due to the market practice of private bond emissions. The Trust Indenture Act (TIA) of 1939 prohibits majority amendment clauses for payment terms. Therefore, an amendment of the payment terms requires the consent of each bondholder under New York law. The TIA was enacted in reaction to concerns that equity owners of corporations could obtain the majority voting power by purchasing the bonds issued by that corporation and afterwards reduce or even suspend the debt for all creditors. Although the TIA does not affect sovereign bonds, it influenced market practice in the New York sovereign bond market. This practice is changing: since 2003, CACs are the common standard in sovereign bonds newly issued under New York law as they have long been under English law.87

3.8.2 Incorporation of CACs

The most convincing argument for CACs is their economic value as the reduction of transaction costs become evident. The currently pressing question is how to imply CACs into preexisting bond, particularly in the present Euro crisis. We have to assume many creditors would reject an exchange offer because they believe they would be in a better position with UACs if the majority of creditors accept the exchange offer. This may lead to a prisoner’s dilemma. To escape this dilemma there seem to be two solutions:

The first solution is a unilateral incorporation by the sovereign. It may have the legal power to make a unilateral change to the bond/loan terms if it chooses his national law as the law to apply. The normative argument against this solution is that the sovereign who chose a peer level of contract should not be allowed to then subordinate the creditor to its coercive power. Additionally, this approval has some substantial economic disadvantages. It opens the door to ex post-opportunistic behaviour of the sovereign who would be able to change the terms in its favour. If it succeeds in a unilateral change of the credit terms, there will not be a foreseeable limit. There is no valid argument why the sovereign would not be able to reduce or even suspend its debts in the same manner. Furthermore, this would have dramatic consequences for credit costs. There is every reason to believe that foreign courts would declare a breach of contract.

The second solution is ‘exit consent’. In negotiations with the debtor the cooperating majority of creditors vote upon those clauses that are free to change due to the unanimous action clauses to the detriment of non-cooperating creditors, so their claims decrease in value.88 This solution is ugly, but it is a private ordering solution without coercive subordination by the sovereign and a promising way to restrict ex post opportunistic behaviour by the debtor and to prevent a hold up situation.

3.8.3 Model Clauses

(1) Majority amendment clause: As it would run counter to a party’s own economic interest to refuse any cooperation if the debtor’s debt burden is unsustainable and no institution is willing to bail out the debtor, an agreement is possible. We have seen that for a minority of creditors there might be a significantly higher profit if they free ride or hold out. Thus a majority amendment clause has to be provided which empowers a (double) qualified majority to vote upon a plan and legally binds the dissenting creditors. The voting power of claims that are directly or indirectly controlled by the debtor has to be suspended to avert misuse.89

(2) Aggregation clause: If groups of creditors each holding different bonds or loans fear a first mover disadvantage, this causes a standoff. To prevent this happening, the different bond/loan contracts have to be connected by an aggregation clause so that all creditors vote upon the plan together and simultaneously.90

(3) Acceleration, legal enforcement, and pro-rata clause: to prevent a rush to the courthouse, only the trustee should be empowered to accelerate and legally enforce creditor rights, although if he fails to act on behalf of the vote of a qualified minority, these restrictions should be suspended. A pro rata clause would establish a right of the trustee on behalf of the creditors to reclaim any payment a free rider receives pro rata.

(4) Coordination and information clauses: In absence of exchange controls, the obligation of the debtor to provide information about his transactions and his economic situation are the most effective protection for the creditors and a prerequisite to valuation of a restructuring offer91 and detection of opportunistic actions.92 To secure compliance with these information duties, the debtor has to be sanctioned if he fails to meet his obligations. Contractual penalties, the right to accelerate the loan or bond and – if the debtor does not correct and complete the required information before the vote upon the plan – the renewal of the original claims would be proper sanctions. It would be the trustee’s and secretariat’s task to distribute the information.

(5) Arbitration clause: The competencies of the arbitral tribunal and the binding force of its verdict have to be determined in the CAC.

(6) Choice of law clause: The material and procedural law to apply (to the arbitral tribunal) has also to be determined ex ante in the CAC. Precise rules confer legal certainty,93 though more abstract rules may be recommended to ensure the required flexibility to react. The application of a sophisticated financial law like New York or English law will be rewarded through low credit costs. This can be explained with the presumption that emerging-market countries especially would tend to change their local law to the detriment of the creditors, not taking into consideration the future increase in borrowing costs.94 Although the majority of sovereign bonds are issued under both New York and English law, we see significant advantages in English law practise over New York law practice. As already mentioned, the TIA is not applicable to sovereign bonds. English law still provides far more flexibility concerning the creation of bond terms for corporate bonds, enabling the creditor’s majority to bind a non-cooperative minority95 – a prerequisite for successful debt restructurings in private ordering procedures. This is an advantage that primarily affects the chances of success for corporate debt restructuring in private ordering procedures. Long-established market practice and experience in the drafting of bond terms for bonds issued by private debtors – particularly in reaction to the latest developments in the financial markets – also contributes to the image of ‘London CACs’ as a prototype for CACs in sovereign bonds.

(7) Obligation to incorporate specific CACs in future bond/loan contracts: At the time of the conclusion of contract, the creditors cannot foresee whether the debtor will incorporate CACs into future loan/bond contracts. This causes calculation uncertainties. For that reason, the debtor should sign a self-commitment to incorporate specific CACs in further loan/bond contracts. If he violates his obligation, the interest rate should rise automatically. Disputes could be determined by the arbitral tribunal.

4. Outlook

Our proposal for reforming the London Club in order to better manage private ordering restructuring of sovereign debts could be helpful for restructuring the debts of Member States of the Eurozone as well. What may be different here are problems of moral hazard. Creditors of sovereign debtors in the Eurozone may charge high interest rates because of existing sovereign risk. They may also expect a bailout of their debtors by the European Union, the European Central Bank, and/or the International Monetary Fond. It had been the goal of Art 125 TFEU (non-bailout provision) to prevent this type of moral hazard, but experience from the financial crisis of peripheral Eurozone members in 2011 and 2012 has demonstrated that moral hazard prevailed. Different types of quasi-bailout have been invented and brought into action, protecting Eurozone members as well as their creditors. The price for these quasi-bailouts is tremendous. It has to be paid by taxpayers of Eurozone Member States, especially by those of net contributors. This price reflects the perils of delayed default. Our proposal for a workable private ordering debt restructuring mechanism for sovereign debtors may be regarded as an exit option from the ongoing costly bailout spiral.


* Prof. Dr. iur. Dr. rer. pol. Dr. h.c. Christian Kirchner, LLM (Harvard), Humboldt University of Berlin, School of Law and School of Business and Economics (

** David Christoph Ehmke, Research Assistant to Professor Kirchner (

*** We are very grateful to Professor Gerhard Dannemann and Christoph Schuller for their helpful comments and advice.

1 A good overview is provided by K Rogoff and J Zettelmeyer, ‘Bankruptcy Procedures for Sovereigns: A History of Ideas 1976–2001’ (2002) 49 (3) IMF Staff Papers <> accessed 30 October 2012.

2 R Coase, ‘The New Institutional Economics’ (1984) 140 JITE 229; M Erlei, M Leschke, and D Sauerland, Neue Institutionenoekonomik (2nd edn, Schaefer & Poeschel 2007); E Furubotn, and R Richter, Institutions and Economic Theory The Contribution of the New Institutional Economics (2nd edn, University of Michigan Press 2005); Christian Kirchner, ‘Public Choice and New Institutional Economics. A Comparative Analysis in Search of Co-op­eration Potentials’ in P Baake and R Borck (eds), Public Economics and Public Choice, Contributions in Honor of Charles B. Blankart (Springer 2007) 19; D North, Institutions, Institutional Change and Economic Performance (Cambridge University Press 1990); R Richter and E Furubotn, Neue Institutionenoekonomik (4th edn, Mohr Siebeck 2010); S Voigt, Institutionenoekonomik (2nd edn, UTB 2009); O Williamson, The Economic Institutions of Capitalism (Free Press 1985).

3 Furubotn and Richter (n 2) 6–7; Richter and Furubotn (n 2) 7; Voigt (n 2) 26–27.

4 Furubotn and Richter (n 2) 7; Richter and Furubotn (n 2) 7; for different types of institutions see Voigt (n 2) 25–33.

5 Voigt (n 2) 22–23.

6 Voigt (n 2) 88–89; Furubotn and Richter (n 2) 5.

7 C Jolls, C Sunstein and R Thaler, ‘A Behavioral Approach to Law and Economics’ in C Sunstein (ed), Behavioral Law & Economics (Cambridge University Press 2000) 13; D Kahnemann, ‘New Challenges to the Rationality Assumption’ (1994) 150 JITE 18; D Kahnemann and A Tversky, ‘Prospect Theory, An Analysis of Decision under Risk’ (1979) 47 Econometrica 263; C Kirchner, ‘New Challenges to the Rationality Assumption, Comment on Kahnemann’ (1994) 150 JITE 37.

8 Voigt (n 2) 237–238.

9 L Rieffel, Restructuring Sovereign Debt – The Case for Ad Hoc Machinery (Brookings Institution Press 2003) 96; G Vitale ‘Multilateral sovereign debt restructuring: The Paris Club and the London Club’ in B Eichengreen and R Portes (eds), Crisis? What Crisis? Orderly Workouts for Sovereign Debtors (Center for Economic Policy Research 1995) 102, 127.

10 Deutsche Bundesbank, ‘Weltweite Organisationen und Gremien im Bereich von Währung und Wirtschaft’ (2003) <> accessed 15 August 2012, 227 ff; Vitale (n 9) 121 ff.

11 Eichengreen and Portes, Crisis?, What Crisis? Orderly Workouts for Sovereign Debtors (Center for Economic Policy Research 1995) 26; Rieffel (n 9) 103; Vitale (n 9) 127.

12 Rieffel (n 9) 108 f.

13 Eichengreen and Portes (n 11) 26; P Power, ‘Sovereign Debt: The Rise of the Secondary Market and its Implications for Future Restructurings’ (1996) 64 (6) Fordham Law Review 2701, 2712; Rieffel (n 9) 103 and 116 f; Vitale (n 9) 127.

14 Rieffel (n 9) 117 ff.

15 Eichengreen and Portes (n 11) 26; Rieffel (n 9) 117; Vitale (n 9) 127.

16 J Fisch and C Gentile, ‘Vultures or Vanguards?, The Role of Litigation In Sovereign Debt Restructuring’ (2004) 54 (1043) Emory Law Journal 1047, 1061 f.

17 Fisch and Gentile (n 16) 1061 f; Power (n 13) 2710 f.

18 Eichengreen and Portes (n 9) 26; Fisch and Gentile (n 16) 1064 f; Power (n 13) 2713.

19 Fisch and Gentile (n 16) 1068 f; Power (n 13) 2715 f; P-H Verdier, ‘Credit Derivatives and the Sovereign Debt Restructuring Process’ (LLM Paper Harvard Law School 2004) 6 accessed 18 November 2013.

20 Ian Vásquez, ‘The Brady Plan and marked-based solutions to debt crises’ (1996) 16 (2) CATO Journal 16 <> accessed 11 October 2012.

21 John Clark, ‘Debt Reduction and Market Reentry under the Brady Plan, Federal Reserve Bank of New York – Quarterly Review Winter (1993) 41 ff <> accessed 15 August 2012,; Power (n 13) 2720 f.

22 R Brown and T Bulman, ‘The evolving roles of the clubs in the evolving of international debt’ (2006) 33 (1) International Journal of Social Economics 11, 21 and 23 f; Fisch and Gentile (n 16) 1072 f; Timothy Geithner and Francois Gianviti, ‘The Design of the Sovereign Debt Restructuring Mechanism – Further Considerations’ (International Monetary Fund, November 2002) 5 accessed 15 August 2012; Group of Ten, ‘Report of the G-10 Working Group in Contractual Clauses’ (26 September 2002) 1 accessed 7 August 2012; J Kämmerer, ‘Der Staatsbankrott aus völkerrechtlicher Sicht’ ZaöRV 2005, 651, 664; A Krueger, ‘A New Approach To Sovereign Debt Restructuring, Statement by the First Deputy Managing Director of the IMF Anne O. Krueger’ (IMF, April 2002) 1 f accessed 15 August 2012.

23 Fisch and Gentile (n 16) 1074 ff.

24 P Buck-Heeb, Kapitalmarktrecht, (4th edn, CF Mueller 2010) 30 para 87.

25 B Rudolph and K Schäfer, Derivative Finanzmarktinstrumente (2nd edn, Springer 2010) 176.

26 A Gelpern, ‘Domestic Bonds, Credit Derivatives and the Next Transformation of Sovereign Debt’ (2008) 83 (1) Chicago Kent Review 170 ff; Verdier (n 19) 60.

27 K Richter, Die Wirkungsgeschichte des deutschen Kartellrechts vor 1914 (Mohr Siebeck 2005) 16; R Richter, Geldtheorie (2nd edn, Springer 1990) 72 f.

28 K Hailbronner, ‘Der Staat und der Einzelne als Völkerrechtssubjekt’ in W Graf Vitzthum (ed), Völkerrecht (4nd edn, De Gruyter 2007) 191.

29 F Cranshaw, ‘Insolvenz- und finanzrechtliche Perspektiven der Insolvenz von juristischen Personen des öffentlichen Rechts, insbesondere Kommunen (Band 7)’ in S Smid, M Zeuner, and M Schmidt (eds) Schriften zum deutschen, europäischen und internationalen Insolvenzrecht (De Gruyter 2007) 68; Hailbronner (n 28) 191.

30 For example: Case 2 BvM 9/03 BVerfG (6.12.2006) paras 32 ff; C Mayer, ‘Staateninsolvenz nach Argentinien-Beschluss des Bundesverfassungsgerichts, Eine Chance für den Finanzplatz Deutschland?’ WM 2008, 425, 429; A Schwenk, ‘Vollstreckungsrechtliche Aspekte zu Klagen geschädigter Gläubiger von Argentinien-Anleihen – Anmerkungen zum Urteil des OLG Frankfurt 8. Zivilsenat vom 29.04.2008 – 8 U 149/07’ jurisPR-BKR 4/2008 Anm. 3 = jurisPR extra 2008, 199, 200.

31 R Pitchford and M Wright, ‘Holdouts in Sovereign Debt Restructuring: A Theory of Negotiation in a Weak Contractual Environment’ (2010) NBER Working Paper No. 16632 <> accessed 15 August 2012; Mayer (n 30) 425, 429 ff; F Sturzenegger and J Zettelmeyer, ‘Has the Legal Threat to Sovereign Debt Restructuring Become Real?’ (2006) Business School Working Papers Universidad Torcuato Di Tella 04/2006, 27–32.

32 Geithner and Gianviti (n 22) 5; Krueger (n 22) 7.

33 C Kirchner, ‘Sovereign Bankruptcy in the EU in the Comparative Perspective – Comment on Leszek Balcerowicz’s paper’ in P Behrens, T Eger and H-B Schaefer (eds), Ökonomische Analyse des Europarechts (Mohr Siebeck 2011) 317, 327.

34 A Makipaa, Bankruptcy Procedures for Sovereign Debtors (University of Heidelberg 2003) 6 <> accessed 15 August 2012.

35 S Müller-Eicker, Strategien zur Restrukturierung von Staatsverschuldungen in Schwellenländern (PhD-thesis, TU Berlin 2011) 80 <> accessed 15 August 2012.

36 S Häseler, ‘Collective Action Clauses in International Sovereign Bond Contracts – Whence the Opposition?’ (2007) German Working Papers in Law and Economics – Paper 5, 2 f <> accessed 15 August 2012.

37 M White, ‘Sovereigns in Distress: Do They Need Bankruptcy?’ (2002) Brookings Paper on Economic Activity 17 <> accessed 15 August 2012.

38 Makipaa (n 34) 21 f; Power (n 13) 2764.

39 M Wright, ‘Restructuring Sovereign Debt with Private Sector Creditors: Theory and Practice’ (2010) Working Paper 4 f and 17 <> accessed 30 October 2012.

40 Mayer (n 30) 429 ff; Makipaa (n 34) 18 f.

41 Mayer (n 30) 430.

42 B Eichengreen, ‘Sovereign Debt Restructuring’ (2003) 17 (4) Journal of Economic Perspectives 75, 79 f <> accessed 15 August 2012; Kirchner (n 33) 324 f; Makipaa (n 34)29 f.

43 S Schlemmer-Schulte, ‘Souveränität und Konkurs – Zur Institutenökonomie der Suspendierung staatlicher Schulden im Internationalen Recht (Rezension)’ ZaöRV 2006, 236, 239.

44 Kirchner (n 33) 326.

45 Kirchner (n 33) 326; Müller-Eicker (n 35) 81.

46 Kirchner (n 33) 326.

47 Group of Ten (n 22) 5 and 17.

48 Rogoff and Zettelmeyer (n 1) 30 f.

49 H Scott, ‘A Bankruptcy Procedere for Sovereign Debts?’ (April 2003) Mimeo 54 accessed 15 August 2012; S-J Wei and Z Zhang, ‘Collateral Damage: Exchange Controls and International Trade’ (2007) IMF Working Paper 4 ff accessed 15 August 2012.

50 Geithner and Gianviti (n 22) 35; Krueger (n 22) 12 and 15 ff.

51 Geithner and Gianviti (n 22) 56.

52 Rieffel (n 9) 116.

53 Rieffel (n 9) 122.

54 Geithner and Gianviti (n 22) 53.

55 Geithner and Gianviti (n 22) pp. 29 f.

56 M Hartwig-Jacob, ‘Neue rechtliche Mechanismen zur Lösung internationaler Schuldenkrisen – Die Vorteile der Anwendung von „Collective Action Clauses“ bei Staatsanleihen’ in KP Berger, G Borges, H Herrmann, A Schlüter, and U Wackerbarth (eds), Zivil- und Wirtschaftsrecht im Europäischen und Globalen Kontext/Private and Commercial Law in a European and Global Context – Festschrift für Norbert Horn zum 70. Geburtstag (De Gruyter 2006) 717, 722 f; Group of Ten (n 22) 2 f.

57 Hartwig-Jacob (n 56) 722 f and 730; Group of Ten (n 22) 2 f and 13 ff.

58 Hartwig-Jacob (n 56) 723 f.

59 F Podewills, ‘Neuerungen im Schuldverschreibungs- und Anlegerschutzrecht – Das Gesetz zur Neuregelung der Rechtsverhältnisse bei Schuldverschreibungen aus Gesamtemissionen und zur verbesserten Durchsetzung von Ansprüchen von Anlegern aus Falschberatung’ DStR 2009, 1914, 1919; F Cranshaw, ‘Internationalisierung und Modernisierung – Bemerkungen zum geltenden und zum Referentenentwurf eines neuen Schuldverschreibungsgesetzes (SchVG)’ BKR 2008 504, 509.

60 Hartwig-Jacob (n 56) 723.

61 Hartwig-Jacob (n 56) 723 fn 22.

62 Makipaa (n 34) 26 f.; Müller-Eicker (n 35) 81; Sturzenegger and Zettelmeyer (n 1) 32 – 35.

63 Hartwig-Jacob (n 56) 731; Group of Ten (n 22) 6 and 13.

64 Hartwig-Jacob (n 56) 733; Group of Ten (n 22) 6 and 14.

65 Hartwig-Jacob (n 56) 732; Group of Ten (n 22) 13 ff.

66 Wright (n 39) 4 ff.

67 For the advantages of permanent institutions in debt restructuring: Eichengreen and Portes (n 9) 20 f and 48.

68 Geithner and Gianviti (n 22) 29 f.

69 Eichengreen and Portes (n 9) 43 f; Rieffel (n 9) 120.

70 Krueger (n 22) 13 and 17 and 28.

71 Makipaa (n 34) 23.

72 Krueger (n 22) 13 and 17 and 28.

73 The concept of the ‘Sovereign Debt Dispute Resolution Forum’ (SDDRF) could be a suitable model. But the decisions of the arbitral tribunal we suggest only become legally binding when accepted ex ante in the CAC. Along this lines: C Paulus, ‘A Standing Arbitral Tribunal as a Procedural Solution for Sovereign Debt Restructurings’ in C Primo Braga and G Vincelette (eds), Sovereign Debt and Financial Crisis (World Bank Publications 2010) 317–329; C Paulus and S Kargman, ‘Reforming The Process of Sovereign Debt Restructuring: A Proposal for a Sovereign Debt Tribunal’ (Conference Paper 2008) <> accessed 21 August 2012. The discussion about arbitration in sovereign debt restructuring: K Halverson Cross, ‘Arbitration as a Means of Resolving Sovereign Debt Disputes’ (2006) 17 (3) The American Review of International Arbitration 335–382 <> accessed 22 August 2012; M Waibel, ‘Opening Pandora’s Box – Sovereign Bonds in International Arbitration’ (2007) 101 (4) American Journal of International Law 711–759.

74 Kirchner (n 33) 332; Paulus and Kargman (n 75) 8.

75 Geithner and Gianviti (n 22) 67.

76 Geithner and Gianviti (n 22) 30 ff.

77 C Paulus, Insolvenzrecht (C.H. Beck 2009) 25.

78 A Bell, Forum shopping and venue in transnational litigation (Oxford University Press 2003) 19 ff.

79 C Kirchner, ‘Umschuldung in Euro-Peripheriestaaten: Restrukturierung von Staatsschulden ohne ein „Insolvenzrecht für Staaten“: Ein gangbarer Weg aus der Krise der Euro-Peripheriestaaten?’ ifo Schnelldienst Nov 2011, 3, 4.

80 Kirchner (n 81) 4.

81 C Paulus, ‘Ein Regelsystem zur Schaffung eines internationalen Insolvenzrechts für Staaten,’ Zeitschrift für Gesetzgebung 4 (2010), 313, 328.

82 L Buchheit and M Gulati, ‘How to Restructure Greek Debt’ (July 2010) Mimeo 8 <> accessed 15 August 2012.

83 Fisch and Gentile (n 16) 1062 f.

84 Fisch and Gentile (n 16) 1101 ff.

85 Geithner and Gianviti (n 22) 52.

86 Group of Ten (n 22) 3; C Ohler, ‘Der Staatsbankrott’ (2005) JZ 590, 598; J Taylor, ‘Sovereign Debt Restructuring: A U.S. Perspective’ (Statement by John B Taylor, Under Secretary of Treasury for International Affairs, Institute for International Economics, Washington DC, April 2, 2002) 2 <> accessed 12 August 2012.

87 R Buckley, ‘The Bankruptcy of Nations: Let the Law Reflect Reality’ (2009) International Lawyer, 20 UNSW Research Paper, 143 ff; S Galvis and A Saad, ‘Collective Action Clauses: Recent Progress and Challenges Ahead’ (Georgetown University 2004) 3 ff and 12 fn 24 <> accessed 15 August 2012; Group of Ten (n 22) 2, 4, and 6 f; Hartwig-Jacob (n 56) 718 f; IMF and World Bank Staff, ‘Guidelines for Public Debt Management’ in Anwar Shah (ed), Fisical Management (World Bank Publications 2005) 128; E Koch (2004), ‘Collective Action Clauses – the way forward’ (2004) 2 f, 6 f, 10, 16 f <> accessed 15 August 2012; A Szodruch, Staateninsolvenz und private Gläubiger (Berliner Wissenschafts-Verlag 2008) 226.

88 M Gulati and L Buchheit, ‘Exit Consents in Sovereign Bond Exchanges’ (2000) 48 UCLA Law Review 59.

89 Group of Ten (n 22) 5 and 10 f and 17.

90 C Blankart and E Fasten, ‘Wer soll für die Schulden im Bundesstaat haften? Eine vernachlässigte Frage der Föderalismusreform II’ Perspektiven der Wirtschaftspolitik 10 (2009), 39, 55; Hartwig-Jacob (n 56) 730 f.

91 Hartwig-Jacob (n 56) 726 f; Group of Ten (n 22) 3 and 16.

92 Kirchner (n 33) 326; Müller-Eicker (n 35) 81.

93 Kirchner (n 33) 332.

94 Buchheit and Gulati (n 84) 10 and 11.

95 Danny Tricot, ‘English Law Bonds’ in Peter Veranneman (ed), Schuldverschreibungsgesetz (C.H. Beck 2009) 187, 190 f; H Foulkes, ‘Bond Creation and Issuance and Bondholder Action under United States Law’ ibid 173, 180 f.

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