Do CACs Constrain the ECB From Buying Even More Bonds?

Answer: No

(This post borrows heavily from the ideas of my co author, Ugo Panizza, of the international economics department of the Graduate Institute in Geneva).

Press accounts of last Wednesday’s emergency ECB Governing Council meeting report that some of the hawks on the Council are resistant to the ECB buying more Euro area sovereign bonds.  The concern being that such purchases might take the ECB’s holdings of particular bond issues to more than a third. If this happens, the ECB would have a blocking minority in any future debt restructuring negotiations where the sovereign is seeking to use its Collective Action Clauses (CACs) to engineer that restructuring.  And (some claim) because voting for a restructuring would amount to monetary financing, the ECB would be forced to vote no and block the restructuring.   Hence, no buying above 33.33% of a bond issue should be done.

This is nuts. Let’s first state the obvious: large ECB interventions will reduce the likelihood that a restructuring will be needed. The reactions of sovereign spreads to President Lagarde’s botched comment that the ECB is “not here to close spreads” and to the successive ECB announcements make this clear.

But let us assume that, even with vigorous ECB intervention, a restructuring is needed and let us take the case of Italy which is what everyone is really talking about.  Close to 99% of Italian sovereign debt is governed by Italian local law. That gives Italy the so-called “local law advantage” (here we focus on Italy, but the local law advantage applies to most bonds issued by euro area sovereigns except Greece and Cyprus).  Translated, it means that Italy has a wide variety of strategies it could use to restructure its debts. 

The collective action clause or CAC mechanism – one where the debt can be restructured in a fashion that is binding on dissenting creditors if a super majority of creditors votes in favor of the restructuring -- is but one of many options that Italy could use to restructure its debt (we describe these options here; see also Weidemaier (2019), here). CACs may be the most market friendly of the various restructuring options, since it requires the approval of a super majority of creditors to work. But it is neither the easiest nor the cleanest restructuring technique for a country that enjoys the local law advantage.  More important, to answer those hawks on the ECB governing council, the restructuring could occur without the need for the ECB to vote one way or the other.

Let us focus on Italy and explain with a couple of possibilities.  The most straightforward is the power to tax.  Most sovereign bonds issued under foreign laws contain provisions that say that if the sovereign imposes a withholding tax on them, that amount has to be reimbursed to the note holders (“tax gross up clauses”).  But 99% of Italian sovereign debt lacks any such clause.  So, Italy can go to its creditors and offer them a restructuring deal and tell those who disagree that it plans to impose a tax on them. 

Will any of the creditors disagree?  Maybe some will threaten litigation on the grounds that such a tax is expropriatory. But remember that these are local law bonds. And that means having to bring suit in Italy. After considering the prospect of having to litigate against the Italian government in an Italian court, before an Italian judge, on a contract that lacks a waiver of sovereign immunity, while the country and the world are facing an existential health crisis, we suspect that few creditors will seek the litigation option. Put differently, one does not need the CAC voting mechanism to incentivize creditors to agree to the deal being offered.

The withholding tax strategy is not fool proof.  Italy has a bunch of bilateral investment treaties with other nations and maybe some of them constrain Italy’s ability to tax citizens of those nations.  In such cases, litigation would likely take place in front of an international arbitral tribunal.  But likely, the number of such cases would be small.

But there probably isn’t even the need to get so fancy and threaten a withholding tax.  If the prospect of being mired in years of litigation in an Italian court is distasteful enough (it is), then litigation oriented creditors will give this context a pass.  Once again, the point is that one does not need to worry about those CAC voting thresholds. 

As we have written elsewhere, there are other options that the Italian government possesses as well, such as that under Article 3 of the Public Debt Act of 2003.  That provision arguably allows Italy to conduct a unilateral extension of maturities (for discussions, see here (Edelen et al 2013) and here (Cervantes et al 2019)). 

Or Italy could look to its own domestic laws that already grant contracting parties relief under unforeseen circumstances that are not their fault (coronavirus surely qualities). Or yet still, there are a variety of self help remedies that other jurisdictions have used in crisis scenarios to produce relief.

China, for example, has used its force majeure laws to considerable effect to grant contracting parties relief who have been unable to perform as a result of the current crisis (here). Along these lines, the governor of the state of New York has used his executive power to make it an unsound banking practice not to extend loan payments for 90 days under these circumstances (here).  Indeed, if one goes back to the Great Depression, there are many more examples of such strategies being used effectively by governments to generate relief for themselves and other vulnerable debtors.*

So, why the sturm and drang over these CAC voting thresholds? Is it that the hawks on the council really think that the ECB crossing the 33.33% holding threshold will make an Italian sovereign debt restructuring impossible? Or are CACs just a fig leaf obscuring other concerns that can’t be made explicit.

*The abrogation of the gold clauses in the 1930s are an example of this. For discussions, see here and here.