Subordinating Holdouts in a Lebanese Restructuring

Mark Weidemaier & Mitu Gulati

Our prior post expressed frustration with the drafting of Lebanon’s fiscal agency agreement, and particularly the collective action clause. The CAC both lacks the aggregation features that are now standard in the market and potentially blocks the use of exit consents. Creditors with a 25% stake in a Lebanese bond issuance would therefore have the whip hand in restructuring negotiations. We noted that this was not the necessary reading of the FAA, but it was certainly plausible given the contract’s idiosyncratic drafting.

But there are other unusual attributes of the FAA that work in the government’s favor, including one that seems to give the government power to subordinate holdout creditors to restructuring participants and other favored creditors.

The oddity appears in the pari passu clause in the Lebanese FAA. This is the same clause, of course, that gave Argentina so much trouble between 2012-2016. Oversimplified, the clause is a relatively ambiguous promise that creditors will be treated equally with other similarly-situated creditors. In Argentina’s case, federal courts in New York interpreted the clause to prohibit the government from legally subordinating one set of bondholders (holdouts) to another (restructuring participants). Argentina violated that prohibition by, among other things, enacting a law in 2005 that forbade the government to pay or negotiate with holdouts. Six years later, the courts ruled that Argentina had violated the clause and issued an injunction that forbade the country to service its restructured debt unless it also paid holdouts in full. (More details here and here.)

Lebanon’s pari passu clause is pretty much the polar opposite of Argentina’s.

The standard pari passu clause says something like this:

The Notes will constitute direct, unconditional and unsecured obligations of the Issuer and rank and will rank equally in right of payment, without preference among themselves, with all other unsecured External Indebtedness of the Issuer…

Here is Lebanon’s pari passu clause (from the 2010 FAA):

The Notes constitute direct, general, unconditional, unsubordinated and . . . unsecured obligations of the Republic which rank pari passu in priority of payment, without any preference among themselves and at least pari passu with all other present and future unsecured and . . . unsubordinated Indebtedness of the Republic, other than any Indebtedness preferred by Lebanese law…

We quote from the FAA here, rather than rely on the language of the bond prospectuses, because we have occasionally found mistakes in how prospectuses describe key terms.* That mistake has caused some to misunderstand the rights investors actually have under the Venezuelan and Italian pari passu clauses, as is detailed here.

Anyway, Lebanon’s FAA explicitly allows it to do what got Argentina into trouble. For instance, it could conduct a debt exchange in conjunction with enacting legislation subordinating holdouts to a wide range of other creditors, including restructuring participants. By itself, such a law wouldn’t accomplish that much. Presumably, holdouts would retain their claims and could sue to enforce them. But it would at least allow the government to make a relatively credible commitment not to immediately cut a better deal for holdouts. And it would make it more difficult for holdouts to complain when the government pays restructuring participants (and everyone else) while leaving holdouts with nothing.

We don’t think we are reading too much into this proviso to the pari passu clause. We’ve coded thousands of pari passu clauses in our research (e.g., here) and seen only a handful that specify that a bondholder’s right to equal treatment is subject to the issuing government’s own law. It’s reasonably common for the clause to allow for unequal treatment when required by “applicable law.” That formulation leaves some doubt about the source of the law. Is it the law designated to govern the bond? The issuing government’s own law? Any law that happens to be applicable? But this clause is crystal clear in giving Lebanon the power to create exceptions to the equal treatment obligation.

One might object that a law subordinating bondholders to other creditors would run afoul of the negative pledge clause in the Lebanese bonds. That clause forbids the government to secure any of its Public External Indebtedness with “any mortgage, pledge or other encumbrance (‘Lien’)” on any of its assets or revenues, unless it also grants an equivalent security interest to holders of the bonds. But the type of subordination envisioned by the pari passu clause doesn’t require the granting of a formal security interest. Indeed, as a historical matter, one understanding of the pari passu clause is that it was designed precisely to protect against informal preferences that did not constitute formal security interests. (We discuss this explanation in the article linked in the preceding paragraph.) The caveat in Lebanon’s pari passu clause seems to give the government freedom to create such preferences.

Anyway, as we note above, this isn’t necessarily a game changer. It doesn’t eliminate holdout claims, make it harder to file suit against the government, or protect the government’s commercial assets abroad. But it’s a weapon in the government’s toolkit.

*There are discrepancies between the prospectus and the FAA here too. The pari passu clause in the FAA promises equal treatment with other “Indebtedness.” The prospectuses for Lebanese bonds often refer only to “External Indebtedness” and thus promise only equal treatment with other holders of foreign currency debt. But “Indebtedness” in the FAA quite clearly includes local currency debt (“all indebtedness of the Republic in respect of monies borrowed … and guarantees given”). This oddity isn’t very important for our purposes, since the clause also allows the government to define categories of preferred creditor.