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The looming New York sovereign debt bills debacle

Gregory Makoff is a senior fellow at the Mossavar-Rahmani Center for Business and Government at the Harvard Kennedy School and author of Default.

Revising the rules of the sovereign-debt restructuring game isn’t simple. For example, adding “collective action clauses” to sovereign bond contracts to deter holdout creditors was a 20-year process.

The idea was first proposed after Mexico’s 1994 Crisis, an initial form was adopted in 2003 after Argentina’s 2001 default on almost $100bn in bonds, and adequately powerful clauses were only adopted in 2014, in the wake of Argentina’s messy litigation in the New York courts and Europe’s debt crisis.

Yet New York is in a rush to do something radical in just a few months. That could cause serious trouble for the sovereign debt market.

Here’s what’s going on: Last year, three groups of senators and assembly members proposed competing laws to favour sovereign debtors over their creditors. The drive for a law was initiated by social activists and legislators angered by Puerto Rico’s debt problems, but broadened and gained energy when Washington-based Jubilee activists joined the effort.

Capturing the mood in Albany, New York State Senate finance chair Liz Krueger said at a recent press conference that:

This is an international issue that is destroying the people of other countries. And too many of these story lines start and end with New York and New Yorkers.

The stated rationale for the three laws are that poor countries are too weak to negotiate for themselves against sophisticated investors, and aggressive hedge funds take advantage of poor countries in New York courts. The draft bills, however, are a grab bag of ideas, rather than a coherent, well-calibrated solution to the stated problems.

The first bill would add a bankruptcy-like debt-adjustment mechanism to sovereign debt issued under New York law. The second would cap the judgments available to creditors at a level established by bilateral lenders in corresponding international debt negotiations. A hedge fund owning a New York law bond, for example, would not be able to obtain a court judgment exceeding the value the U.S. had accepted in exchange for its defaulted loans in a Paris Club negotiation.

The third bill would restore to New York State law the champerty defence for sovereign defaulters, which the legislature removed for claims of more than $500,000 in 2004. With the reinstatement of this provision, court judgments would be blocked on debt found to have been purchased with the “intent and purpose” to sue.

Top law firms question the legal soundness of the first bill, the proposed sovereign bankruptcy mechanism under New York law. Under the US Constitution, bankruptcy laws are to be enacted only by the US Congress, and only federal courts handle bankruptcy cases. The proposed law, however, would have the governor of New York appoint a “monitor” for the restructuring of sovereign debt, allow the debtor country to “petition the state for relief,” and would allow the country to file a “plan” with New York State to adjust its debt.

Furthermore, this ambitious scheme lacks detail, not even identifying a specific court to adjudicate disputes, even though disputes will inevitably arise on day one. While purporting to add a collective voting mechanism to New York law, nowhere in the law or in supporting materials is there any discussion how the new mechanism would work alongside collective action clauses that are now already included in most sovereign bonds.  

The second bill, which caps judgments to private creditors, is also poorly designed. For one, its scope is too wide: It applies to all borrowers, while a similar law passed in the UK in 2010 applied only to countries with a GDP per capita of about $1,500. Second, it’s open for abuse, as it would allow the US Treasury to dictate the cap applicable to private creditors even when bilateral creditors lack skin in the game. The Treasury could, for example, dictate terms even when private creditors have provided 98 per cent of the relevant debt and bilateral creditors only 2 per cent.

The third bill is less threatening as champerty has long been part of New York State law and its effect is known. The need for a law, in part, is because an exception was carved into the law in 2004 to protect holders of claims larger than $500,000, which was to the benefit of investors intending to hold out from sovereign debt restructurings. The proposed bill would remove this exception with respect to sovereign debt claims. That champerty works against litigious investors was proved in 1998, when Peru successfully used a champerty defence against Elliott Associates in the district court, although it was reversed on appeal.

Still, the wording of the bill as it currently stands could catch conventional investors. To work without disrupting the market it would need to provide an unambiguous ‘safe harbour’ provision so that it would apply only to investors that make a business of suing, and exempt regular buy-and-hold investors and distressed debt investors with a record of co-operating with sovereign debt restructurings.

Creditors and legal experts are gobsmacked that legislative leaders have lined up behind an amalgamation of the first two bills, the ones with the biggest problems, with activists and legislators announcing at a March 13 press conference their intention to pass the merged law by June.

Creditors are livid that the feedback they provided over the past year has seemingly been completely ignored. They contend that the draft law would raise the cost of finance for poor countries, and they’ve threatened to move the sovereign debt market to Texas, Delaware, or some other jurisdiction that won’t try to change the laws without consultations.

Moving for a vote with badly drafted bills and the market in an uproar would be a regrettable mistake. What’s needed is an open conversation and sufficient time for the legislature to draft a workable bill. The next step should be for the New York State Senate finance committee to announce hearings on the proposed laws. Proponents, opponents, the IMF, and the US Treasury should be invited to testify, as should finance ministers of developing countries, who do not appear to have been consulted on any of the draft bills.

While holding hearings might push enactment past June, they are a necessary step if the legislature wants to enact a bill supported by debtors and creditors in the sovereign debt market. Importantly, compromise is possible: Most investors do not like aggressive holdout investors because they disrupt the market, which is why investors accepted powerful holdout-stymieing CACs in 2014. If it changes course, New York legislators could succeed in carrying out a successful reform.

New York lawmakers, however, need to keep in mind that even the final enhancement of CACs in 2014 took the US Treasury two years to achieve. But a decade later, those two years look short. Today around 80 per cent of all sovereign bonds include these new clauses, and two significant 2020 debt restructurings — for Argentina and Ecuador — used the new clauses. This reform was a massive success, and the new clauses were accepted by the market at no incremental cost to sovereign borrowers.

But this result was not a matter of luck or good timing; it was instead the result of careful analysis and lengthy worldwide consultations with sovereign debtors and creditors. New York State lawmakers should learn from this experience and slow down, invite discussion, and design a new, more carefully calibrated law.


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