Lebanon’s Vexing Modification Clause

Mark Weidemaier and Mitu Gulati

We posted earlier about Lebanon’s befuddling fiscal agency agreement. Understanding what exactly the modification provision in this contract means to say is key because Lebanon is in the process of trying to restructure its obligations to bondholders. 

To recap, the chief oddity is that the agreement seems to have only one voting threshold for modifying the bonds (75%).  That makes it relatively easy for dissident investors to block a restructuring. A typical sovereign bond has two voting thresholds, a higher one for payment-related and other “core” terms and a lower one for non-core terms (usually 50%, but sometimes 66.67%). If Lebanon’s bonds lack a lower voting threshold for non-core terms, this would negate the government’s most feasible restructuring strategy, which would involve the use of exit consents to discourage holdouts.  Now, in theory, it is possible that Lebanon and its creditors consciously negotiated a special type of sovereign debt contract totally precluding the use of exit consents. But if that were the case, we’d think that everyone involved (creditors, debtors, rating agencies and so on) would have been aware and this matter would have been prominently flagged on the front pages of the offering document.  Best we can tell, none of that happened.

So, assuming there is no evidence that this was a specially designed anti-exit consent vehicle, the next question to ask is what arguments can be made for enabling the use of the technique. We see two arguments—closely related but distinct—for allowing the government to modify non-core terms at a voting threshold lower than 75%. Apologies; this will be a bit technical.

First, a brief recap of the problematic parts of the FAA (at least the ones most relevant here; there are lots of problematic parts…). For simplicity, we’ll confine our discussion to modification votes taken at a meeting:

Paragraph 15 of the Terms & Conditions of the Notes, found in Schedule A to the FAA, is structured more or less like a typical collective action clause. It notes that the FAA contains provisions allowing bondholders to modify the bonds. But there is a proviso (“provided that …”) that identifies five core terms, including payment terms, that may be modified only with the consent of holders of 75% in aggregate principal amount of bonds represented at the meeting. The implication is that the five core terms are subject to the highest voting threshold of 75%; other terms are subject to voting provisions elsewhere in the FAA. If so, that’s basically your standard CAC.

But… the FAA specifies only one voting threshold, for so-called Extraordinary Resolutions. It’s the 75% threshold. This is in par. 1(c) of Schedule I (“Provisions for Meetings of Holders of Notes”). Hmm.

Paragraph 19 of Schedule I tells us that, at a meeting, “Holders of Notes shall … have power exercisable by Extraordinary Resolution” to take certain steps. Most relevant, 19(a) says holders have the power by Extraordinary Resolution “to sanction any proposal by the Republic for any modification … in respect of, the rights of the Holders of the Notes against the Republic …” Again, however, there is a proviso (“provided that”) relating to core terms. Here, par. 19 specifies that any meeting to consider an Extraordinary Resolution that will affects core terms must satisfy a higher quorum requirement. As we said in our prior post, it makes no sense to use the quorum requirement to indirectly affect voting thresholds.

The most problematic interpretation of these provisions (from the government’s perspective) has two parts. First, “any modification” that affects the rights of bondholders must be by Extraordinary Resolution (Sch. I, par. 19(a)). Second, all Extraordinary Resolutions must satisfy the 75% voting threshold. So interpreted, the contract is unambiguous and complete, with no gaps to fill. All modification votes must pass with a 75% vote.

We think, however, that there are at least two arguments that the government can make to the contrary. 

1. There is a Gap

The government’s first argument is that the foregoing interpretation is obviously wrong—that it fails at step 1. To be sure, the FAA envisions that non-core terms may be modified by Extraordinary Resolution, but it does not require this. The only language even arguably to the contrary is in par. 19(a) of Schedule I. But this language merely tells us that bondholders “shall have the power” to approve any modification by Extraordinary Resolution. Well, of course they do. And there will be times when it makes sense to apply the highest voting threshold even to relatively minor modifications. For instance, the issuer might propose to change both core terms and non-core terms and want the proposal to stand or fall together. The most efficient way to conduct this vote is to present both changes for approval at the 75% threshold required for an Extraordinary Resolution (which would necessarily have to be satisfied for the modification to core terms).

However, to say that all modifications may be made by Extraordinary Resolution is not to say that they must be made that way. That's not the intuitively correct reading, and it is not what par. 19 of Schedule I says. Put simply: nothing in the FAA expressly requires all modifications to satisfy the 75% threshold.

Having made this argument, though, the government still cannot point to anything in the contract that specifies a lower voting threshold. But this simply leaves a gap in the contract, easily filled with evidence of market practice (which generally provides for either a 50% or 66.67% threshold for modifying non-core terms). Once the gap is filled, the lower voting threshold opens up space for the use of exit consents.

2. Who Gets to Fill the Gap?

The preceding argument is basically about how the FAA should be interpreted. A federal judge in New York will look at the FAA, using the usual tools of contract interpretation. If the court agrees that the FAA contains an important gap, the government will win. If not, the government will lose. 

The government’s second argument offers the possibility of winning even if a court, left to its own devices, would reject the government’s interpretation of the FAA. This argument relies on the government’s power, in par. 23.1 of the FAA, to “cure any ambiguity” or to “correct or supplement any provision … that may be inconsistent … or that is otherwise defective.” The caveat is that the change “shall not adversely affect the interest of any Holder of Notes in any material respect.”

As Mitu’s last post pointed out, some student papers in the joint Duke/NYU sovereign debt class this semester have focused on this power. Here, we assume the government unilaterally modifies the FAA to expressly include a lower voting threshold (say, 50%) for non-core matters. As we read par. 23.1, it has the power to do this—even if a court would otherwise interpret the FAA to require a 75% threshold for all votes—as long as the change does not adversely affect bondholder interests.

Does it? If we look at the question from the perspective of bondholders as a collective, it is easy to argue that the change does not have an adverse impact. Any voting threshold attempts to strike a balance between two kinds of opportunistic behavior. First, there is the risk that the issuer of the bonds will opportunistically try to relieve itself of its obligations when it can afford to honor them. Second, there is the risk that a small subset of creditors will try to extract a preferential settlement by blocking a modification that would benefit creditors as a group. The almost uniform practice in international sovereign bonds is to set a high voting threshold when the risk of sovereign opportunism is at its greatest (i.e., with respect to core matters) and a lower threshold when the risk of creditor opportunism is greatest (i.e., for non-core matters). That widespread practice (and more than a little empirical research) suggests that it might actually be in the best interests of creditors to insert a lower voting threshold into the agreement.

The problem with this argument is that the language of Lebanon’s FAA seems to ignore the collective interests of bondholders. Instead, it forbids the government to alter the agreement if the change will adversely affect any Holder in any material respect. And of course, prospective holdouts can easily characterize the use of 23.1 as adverse to their interests, because the insertion of a lower voting threshold effectively dilutes their vote. Thus, it may be that arguments under par. 23.1 collapse into arguments about contract interpretation. Lebanon will win if the court agrees that the FAA has a gap that should be filled (whether by the court or by Lebanon under par. 23.1) with a market-standard voting threshold for non-core matters. Lebanon will lose if the court thinks the contract requires a 75% vote for all modifications (defeating both Lebanon’s contract interpretation argument and its argument that 23.1 gives it the power to add a lower voting threshold).

On the other hand, perhaps there is an argument that the addition of a lower voting threshold does not harm even prospective holdout creditors? That’s the argument the government needs to make to successfully invoke par. 23.1. And this strikes us as a harder case for the government to make.  It is an intriguing possibility though.