The Local Law Advantage in the Euro Area: How Much of a Constraint a...

Collective Action Clauses for the Euro Area were mandated, starting in January 2013.  Yes, bizarrely, even though the introduction of Euro CACs was literally the single biggest innovation in sovereign bond contract terms in the history of this market, no one seems to have a clear idea of how these CACs (contractual restructuring mechanisms) are actually going to operate.  Specifically, if a Euro area country needs to restructure some day soon (e.g., Italy?), and it has a subset of bonds with these CACs (by next year, Italy will have something close to a super majority of its bonds with these Euro CACs), is it required to use the CACs to do the restructuring or can it use other mechanisms? That is, regardless of the presence of these CACs, can the sovereign still take advantage of the fact that almost all of its multi trillion dollar debt stock is governed by Italian local law to engineer the restructuring (the "local law advantage" in the words of sovereign debt guru Lee Buchheit)?

Most people I know in the European sovereign debt world take the view that the CACs will have to be used if they are in the bonds (it is a different question altogether as to what can be done with the subset of bonds without CACs and also under local law).  And, indeed, that may be why there is currently a move to reform and improve the first-generation of Euro CACs (they appear, on their face, quite vulnerable to hold outs).  But do the Euro CACs have to be used to engineer the restructuring, if the bond that needs to be restructured has them?

As an aside, some of you may remember this question recently came up in the context of measuring redenomination risk in Euro area bonds, where because of the assumption that the bonds with CACs were protected against unilateral redenomination of the currency on the bonds by the sovereign, some were trying to use the CAC bond versus No CAC bond yield differential as a measure of redenomination risk. [This is not at all a crazy position, since the CAC bonds require a supermajority approval of creditors (roughly) for a change to the currency of the bond]

Our fellow slipster, Mark Weidemaier, has a superb new paper (here) that suggests the foregoing thinking is misguided. Best I know, Mark's paper is the first one to address this central question about Euro CACs under local law head on (although I'm optimistic that some of our students will have good papers exploring this very question in greater depth soon).  My prediction is that there are many who will disagree strongly with Mark; particularly those who see the Euro CACs as representing some sort of holy European treaty promise.  But Mark makes a powerful argument that that view is more smoke than fire.  Euro CACs, according to him, are nothing but an option for the sovereign.  That's it, he tells us; they are nothing more. The sovereign can choose not to use this option and take an alternative (easier) route to doing its restructuring.

To quote from Mark's recently posted paper (emphasis added):

The combination of local law advantage and Euro CACs creates one of the central uncertainties affecting any restructuring of Euro Area sovereign debt. History teaches that borrower governments can easily restructure debt governed by their own laws. But this intuition co-exists with a widespread sense that Euro CACs make it harder for governments to exploit local law advantage. The reasons are often left unstated but seem driven by the view that governments must use the Euro CAC to restructure. So understood, Euro CACs are a mixed blessing. They open a new path to debt relief for a sovereign that can win the support of a bondholder majority, the size of which is defined ex ante. But they impede other paths, which a desperate (or opportunistic) sovereign might travel to ease its debt burden.

In this paper, I explain why I do not think Euro CACs have this effect. To summarize the argument: I doubt that Euro CACs materially constrain local law advantage. From the perspective of the restructurer, Euro CACs represent the safe option, not the only one. A sovereign that satisfies the Euro CAC’s voting requirements can rest easy; its restructuring will leave no holdouts and will survive almost any legal challenge. But a sovereign that has issued local-law debt remains free to alter its law to facilitate restructuring. This path involves more risk. The sovereign is constrained by its own law and institutions, by international law, and (in the Euro Area) by European law and institutions. Yet the constraints are not absolute; there is room for the prudent exercise of local law advantage. I doubt a Euro Area sovereign would eschew CACs without good reason, but the option is there.