Raise a glass to freedom . . . from debt restructurings

Mark Weidemaier and Mitu Gulati

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Mark and Mitu teach classes on international debt at the Universities of North Carolina and Virginia respectively They co-host the sovereign debt podcast Clauses and Controversies. The Spring meetings of the World Bank and IMF concluded recently. The main topic of conversation was China. China’s failure to play nice, the story goes, is gumming up the works and delaying the resolution of sovereign debt crises. But there are other problems, including one raised by a mostly-overlooked lawsuit pitting St Kitts’ Hamilton Reserve Bank against Sri Lanka. If the case goes as we expect, it will complicate the Sri Lankan restructuring and offer a preview of what may happen in other debt restructurings. Put simply, delays by official creditors create a window for private creditors to exclude themselves from a bond workout.

First, some background: Most emerging market international sovereign bonds contain collective action clauses that allow all of the country’s bonds to be aggregated for voting purposes. If a supermajority (typically between 66.67 per cent and 75 per cent) votes in favour of a restructuring proposal, all are bound. The benefit of aggregation is that the amount of debt being restructured is too large for a lone creditor, or a small group, to hold out from the deal and demand a premium. But not all bonds allow for an aggregated vote. Many older bonds require a supermajority of each bond series to approve the restructuring, which allows holders with smaller positions to block a restructuring. The Hamilton Bank lawsuit concerns a bond issued by Sri Lanka in 2012, which matured in 2022. The bond lacks aggregation features and has long been flagged as vulnerable to “holdout” creditors. Hamilton Bank appears to have a blocking position in the $1bn bond, holding roughly $250mn in principal value. That alone is not much of a surprise. Again, the 2022 bond was known to be vulnerable to such tactics. It’s the main reason why it had consistently traded at a premium to other Sri Lankan bonds

. What is surprising is that Hamilton Bank has resorted so soon to the litigation process. A common holdout strategy to stay hidden until a restructuring has garnered broad creditor support and then to threaten to undermine the entire deal by blocking the restructuring of one bond (unless, of course, a big fat premium is paid). It is more unusual for a holdout to announce itself early by bringing suit before restructuring talks have even gotten going. Among other reasons for delaying litigation, interest on a legal judgment typically accrues at a rate lower than most emerging market bond coupons. With rising interest rates, the rate of post-judgment interest has gone up, but not that much. Another strange aspect of the Hamilton Bank lawsuit is that Sri Lanka responded aggressively, seeking to have the case dismissed on legal grounds of dubious merit. Generally, there isn’t much to fight about in a sovereign debt lawsuit.

The sovereign borrowed money and didn’t repay. That’s easy: judgment for plaintiff! Why pay expensive lawyers to fight an inevitably losing battle? The answer, we suspect, is that Hamilton Bank’s lawsuit may give it additional protection against restructuring. A creditor with a blocking stake is in a strong position but still vulnerable to a debt restructuring. Among other reasons, a position large enough to block a restructuring of payment obligations may not be large enough for the creditor to block other types of modifications. The Sri Lanka 2022 bond, for instance, requires 75 per cent of holders to approve a change to payment and other important terms, but only two-thirds support to change less important terms. Hamilton Bank’s stake is large enough to block votes in the former category, but not the latter. Clever debt restructurers can sometimes find ways to squeeze potential holdouts by threatening to modify even relatively unimportant terms. As long as Hamilton Bank’s rights derive only from the bond, it remains vulnerable to such tactics. Once Hamilton Bank gets a court judgment, however, Sri Lanka’s ability to squeeze it diminishes. A court’s judgment exists and is enforceable independently of the contract (we discuss this more here). So even if Sri Lanka’s other creditors agree to take less than 100 per cent of their claims, Hamilton Bank remains free to enforce its judgment, including in other jurisdictions. If Hamilton Bank succeeds in getting paid other creditors may try to replicate the strategy in future debt restructurings. Ordinarily, few creditors would consider this move. But they will take it more seriously if restructuring talks continue to drag (thus giving time for litigation to produce a judgment) and if Treasury yields stay high (thus making the rate of post-judgment interest relatively attractive).

There remain many unanswered questions about how judgment holders will fare in a debt restructuring. It may be possible to modify a bond in ways that do affect the judgment holder’s rights. In some cases, for instance, the country and its remaining creditors might agree to remove the sovereign immunity waiver from the bond, thus making it difficult for the holdout to enforce its judgment. This strategy doesn’t seem to be available for the Sri Lanka 2022 bond, which requires 75 per cent approval to change the immunity waiver. But there may be other ways for Sri Lanka and its remaining creditors to modify the bond to put the squeeze on Hamilton. Whether they can do this depends in part on Hamilton Bank’s voting rights after a court enters judgment on the bonds. From what we can tell, the bonds would fit under the contract definition of “outstanding” (and hence entitled to vote) even after the entry of judgment. Bottom line: A judgment holder is insulated from many of the most common restructuring techniques and may, while in its protected cocoon, still be able to interfere with the rest of the restructuring. Last we checked, the 2022 was trading at only a slight premium over the other Sri Lankan bonds. Maybe the market is anticipating Sri Lanka pulling a rabbit out of a hat and completing the restructuring before Hamilton gets a judgment. Time will tell. What is clear is that the long delays caused by official sector squabbling are creating new strategic options for private creditors.