Trouble for emerging markets brewing in Albany?

There is trouble brewing in Albany for emerging markets investors and issuers.

For decades borrowers and lenders trusted New York law with the governance of their agreements; after all, New York law is the gold standard for protecting property rights, recognizing the sanctity of a contract and ensuring impartial, predictable and consistent administration of justice.

State legislators in New York have introduced three bills in the 2023 session that would undermine the enforceability of sovereign debt contracts governed by New York law. Although these are state-level bills, many sovereign debt offerings will be affected as more than half of all sovereign bond contracts are under the purview of New York law. All three proposed bills have found interest in both the Senate and the Assembly and the Fahy Bill (Senate Bill S4747) is in the Committee stage of the process. The three bills are summarized below:

Krueger Bill (former Assembly Bill A9317)

This bill would limit the ability of a sovereign bondholder to recover if there is a history of purchasing sovereign debt at a discount or declining to participate in a sovereign restructurings. It is based on a the legal concept of champerty which prohibits unrelated parties from providing support for consideration contingent on the outcome of litigation. A champerty defense would remove secondary market buyers of debt issued by sovereigns with declining credit metrics because such a defense would eliminate those buyers’ ability to seek recoveries. Currently investors that lack size or expertise to manage a distressed restructuring will sell to a dedicated distressed fund. A champerty defense would trap investors in deteriorating sovereign bonds with liquidity only being offered by the issuer itself.

Due to higher interest rates secondary bond prices have fallen to below face value for approximately 85% of the JPM Emerging Market Bond Index. Any investor therefore risks being accused of champtertous behavior simply by engaging in their normal course of business. 

Fahy Bill (Senate Bill S4747)

This bill would cap creditor recoveries at an indeterminate amount equal to what the US federal government might have received had it been a creditor. It would retroactively reduce existing judgments and override existing, carefully negotiated collective action clauses, which allow a supermajority of bondholders to agree to a debt restructuring that is legally binding on all holders of the bond, including those who vote against the restructuring.

From an investors perspective, the Krueger Bill increases the probability of default by giving the borrower too much leverage while the Fahy Bill increases the loss given default.

Davila Bill (Assembly Bill A2102)

This bill would empower New York courts to supervise sovereign debt restructurings while giving debtors the exclusive power to propose a restructuring plan. The law would affect the entire existing sovereign debt stock because it would apply retroactively and explicitly override existing bond contracts.

There is no criteria for determining whether a sovereign is eligible, what debt relief the borrower requires and the process would be overseen by an entity selected by the New York State Senate Finance Committee without the consent of bondholders.

Implications

Argentina’s drawn out restructuring following its default in 2001 is most frequently cited as driving the need for this legislation. However, the challenges Argentina faced with holdouts no longer exist. The International Monetary Fund found in 2020 that “almost all international sovereign bonds include some forms of” collective action clauses, which  “could help facilitate debt restructurings.”¹ Foreign states also revised the pari passu clauses to eliminate holdout rights in bonds issued since 2014.²

Although some bonds that lack collective action clauses are still in circulation, fewer than 3.6% of sovereign restructurings have led to litigation in the last 50 years.³ Between 1997 and 2014, 95% of creditors consented to restructurings.⁴ More than a dozen countries, provinces and cities successfully restructured since 2017.⁵ And though many feared that Covid-19 would push countries to “the brink of a new, disorderly default,” that didn’t happen.⁶ Creditors agreed to reasonable repayment terms for Ecuador, Argentina and several Argentine provinces.^7,8

All three bills are well intentioned. They attempt to improve foreign debt restructurings by standardizing recoveries and eliminating holdouts. The concern is that every restructuring has different characteristics that require different expertise, approaches and solutions. It can be easy to consider the behavior of a distressed investor as unproductive or unnecessary. However, distressed investors are an important part of the market ecosystem and are incentivized to reach acceptable terms as sovereign immunity makes it extremely difficult and expensive to collect from a foreign state. Without them there would be limited liquidity in the secondary market for debt issued by sovereigns with weak or declining credit metrics. Instead of allowing the market to determine the price, investors looking to sell a declining sovereign credit may have to rely on a charity bid from the sovereign itself.

If any of these bills becomes law, we are concerned about the unintended impact on liquidity as well as increasing borrowing costs for New York-issued sovereign debt. The U.S. Court of Appeals for the Second Circuit has singled out this factor in the past. When it is more difficult to enforce indenture rights against sovereign states, it is harder for “holders of debt instruments” to sell those bonds on secondary markets. Disrupting the secondary markets in this way makes it riskier, and thus more costly, for higher risk, developing countries to borrow. Increasing the cost of New York-issued sovereign debt will encourage developing market sovereigns to issue debt outside of the New York legal framework or increase bilateral debt further reducing liquidity.

Emerging economies rely on the ability to raise money on the sovereign debt market to fuel their development needs. Investors are willing to purchase this debt because a stable and predictable enforcement system allows them to collect. Altering creditors’ rights, particularly through ex post facto legislation, is a disruption that makes it riskier, and thus more costly, to lend to the developing countries the bills purport to protect.

While we support improving restructuring efficiencies, we are concerned that apparent philanthropy will negatively  impact market liquidity and the cost of capital.

^1,5 The international architecture for resolving sovereign debt involving private-sector creditors—recent developments, challenges, and reform options.

² Sovereign bond contract reform: Implementing the new ICMA pari passu and collective action clauses.

^3,4Study group on sovereign bankruptcy. 

⁶How to avoid a new Argentina default?

⁷Ecuador basks in glow of debt-restructuring success.

⁸Argentina defuses default crisis with ‘massive’ debt deal.