How to Destroy the Collective Action Clause

Mark Weidemaier & Mitu Gulati

We almost hate to post this, because it is so simple, and so fundamental, that it seems almost surely wrong. But if it’s wrong, we can’t see why. Maybe a reader can explain? Here goes.

For at least 20 years, reform efforts in sovereign debt markets have promoted collective action clauses (CACs) (here and here). The current version of the clause was drafted by a super-committee of senior lawyers, investors, and finance ministers – many of them people for whom we have enormous respect. It lets the sovereign bond issuer hold a restructuring vote across multiple series of bonds in a so-called aggregated vote. Before, most CACs in the market required a vote for each series of bonds. The point of the reform was to make it impossible for litigious holdouts to exclude one or more individual series of bonds from a restructuring that had garnered the support of a creditor supermajority. But—and here’s the important point—outside of the euro area, these aggregated CACs are reserved for bonds issued under foreign law. They don’t have to be. But contract reform to solve the holdout problem hasn’t seemed important for bonds governed by local law, which the sovereign can already restructure just by changing its law.

Most sovereigns issue most debt under local law. So, here’s the CAC destroying idea:

Phase 1, the sovereign restructures its local law debt (either by passing legislation or by asking bondholders to tender). The restructured bonds might or might not include new financial terms. What they definitely will now include is a modification provision substantially similar to the one that appears in its foreign law debt. However, the restructured bonds are still governed by local law.

Phase 2, the sovereign proposes a restructuring of the entire debt stock, aggregating the vote of local and foreign law bonds together.

Holders of local law bonds are pliable. Many will be local institutions subject to the government’s sway. Even if not, they will be pliable because they hold local law debt, and the sovereign can put the screws to them whether they consent or not (the so-called “local law advantage,” see here, here, and here). So they will vote in favor of the restructuring. If there is any doubt, the terms can be sweetened slightly, relative to the new financial terms, if any, included in the phase 1 restructuring. Holders of foreign law debt will have their vote diluted—in some cases, utterly swamped—by the favorable local-law vote, and the issuer can impose restructuring terms on everyone.

Best we can tell, nothing in the new aggregated CACs prevents this. It seems the only requirement for a bond to be included in the aggregated vote is that it satisfy the definition of “Debt Securities Capable of Aggregation.” For instance, here’s the provision in Sri Lanka’s newer bonds allowing it to conduct a fully aggregated (“single limb”) vote:

In relation to a proposal that includes a Reserved Matter, any modification to the terms and conditions of, or any action with respect to, two or more series of Debt Securities Capable of Aggregation may be made or taken if approved by a Multiple Series Single Limb Extraordinary Resolution or by a Multiple Series Single Limb Written Resolution...

...

A “Multiple Series Single Limb Written Resolution” means each resolution in writing (with a separate resolution in writing or multiple separate resolutions in writing distributed to the holders of each affected series of Debt Securities Capable of Aggregation, in accordance with the applicable bond documentation) which, when taken together, has been signed or confirmed in writing by or on behalf of the holders of at least 75% of the aggregate principal amount of the outstanding debt securities of all affected series of Debt Securities Capable of Aggregation (taken in aggregate).

And, crucially, here’s the definition of Debt Securities Capable of Aggregation:

“Debt Securities Capable of Aggregation” means those debt securities which include or incorporate by reference the provisions described in “Modifications and Amendments; Meetings of Holders” and “Aggregation Agent; Aggregation Procedures” or provisions substantially in these terms which provide for the debt securities which include such provisions to be capable of being aggregated for voting purposes with other series of debt securities.

We don’t see how these provisions prevent a restructuring like the one we have described above. A local-law bond retrofitted with a substantially similar modification clause seems to be a Debt Security Capable of Aggregation. (To be safe—since the security must “include or incorporate by reference” the voting provision—the issuer might want to do a tender offer rather than simply pass a law inserting the CAC into its local-law debt.) Nor can we find anything else in the contract to prevent this. But the new CACs are so looooooooooooong. And complicated. Maybe we are missing something obvious. It would not be the first time.

Now, is this plausible? Our initial thought is that an issuer would have to be feeling pretty frisky to try something like this. Wouldn’t investors go beserk? On the other hand, why should they? This isn’t a case of finding some ambiguous clause and asserting a new meaning for it (remember pari passu?). This clause is in plain sight. Hard to see any court finding what we have described in phases 1 and 2 as a violation of good faith. Do we think it is sneaky? Maybe a little. But we are also a bit embarrassed that we didn’t see the implication of this language till now. It is staring at us in black and white.

Bottom line, if we are reading the language right, the new CACs have a gigantic exploit built in, one that basically swallows the CAC whole. Issuers like Sri Lanka (or Russia), with large local-law debt stocks, may have a LOT more leverage than they think. Indeed, given this clause, one might ask: Would a debt restructurer be duty bound to at least advise their client of this option?