CashNews.co
Jay Newman was a senior portfolio manager at Elliott Management. Nick Kumleben is energy director at Greenmantle. Richard Carty was Managing Director of Morgan Stanley Principal Strategies and CEO of Bonanza Creek Energy
Sovereign debt defaults are a disaster for private creditors, but folks owed money by Venezuela may soon have an opportunity to reset a dysfunctional process — and put an end to creditor-on-creditor violence.
Over the last 25 years, a tag team comprised of sovereign debtors, the European Union, the G-20, the Paris Club, the IMF, and the professoriat has marginalised the role and influence of private creditors of sovereigns.
First, they eviscerated bond contracts with changes large and small — particularly the insertion of complex collective action clauses (CACs) that are designed to be manipulated by debtors. As a result, sovereign debt contracts have become functionally unenforceable: unrecognisable as conventional credit instruments. Then, they adopted the innocuous-sounding but pernicious “Common Framework”, which relegates private investors to afterthought in sovereign restructurings.
In this world, bondholders, arbitration award claimants, and trade creditors find themselves crouching in a corner, acting as if they have no choice but to accept the abuse and dregs handed down by the official sector. China is now following suit, forcing unprincipled, politically expedient terms that minimise recoveries by other private creditors.
It should not be this way. And if creditors wake up — it won’t.
Why have some of the world’s most sophisticated institutions and investment firms allowed themselves to be co-opted and drawn into a process that relegates them to supplicancy?
The short answer: creditors of sovereigns have a collective action problem. They haven’t sorted how best to collaborate to maximise their intrinsic leverage, and avoid working against each other.
It’s a common problem. Corporate creditors are still trying to solve the puzzle of collaboration. Increasingly, participants in corporate restructurings avoid creditor-on-creditor violence by committing to cooperation agreements. There is no reason something similar can’t work when the debtor is sovereign. After all, the fundamental principles are the same. Debtors are expected to abide by the rule of law, honour contracts, reorganise their affairs, replace management as needed, and pay what they are able.
In fact, the statutory framework applicable to sovereign hard-currency indebtedness contemplates nothing less. The Foreign Sovereign Immunities Act (FSIA) and the State Immunity Act (SIA) provide that when sovereigns waive immunity and engage in commerce (eg, borrowing money, inducing foreign investment) they’re to be treated the same as commercial enterprises.
Alas, in the world of sovereign debt, things have gone wildly off track. During the 1980s, when most sovereign creditors were commercial banks, negotiations were handled by money centre banks (the “London Club”). Those banks had the expertise — and the votes. But by the 1990s, the debt stock shifted from bank loans to publicly traded bonds, and bond holdings were less concentrated. The creditor class became less homogeneous, unified, and capable of acting in concert. Empowering a cohesive core to negotiate for the whole seemed impossible.
The creditor committees that replaced bank-led groups have been nonstrategic and weak for decades. They’re ad hoc: unstable because members come and go as they trade in and out of their bonds. They’re frequently dominated by creditors with short-term horizons and succumb to the lowest common denominator under pressure from the official sector: accepting quick and dirty deals that make no pretence of dealing with underlying issues like corruption and economic policy. Worse, some creditors use debt restructurings to promote social and political goals — their CEO may want a cabinet job — rather than protecting shareholders and clients. Oddly, other creditors are sightseers — schmoozers who love the drama of being at the table and show up to socialise.
All this flies in the face of the reality that by pooling their votes and installing centralised, professional management to represent the whole, bondholders could create the only leverage that really matters: controlling access to international capital markets until legacy debt and financial obligations have been resolved.
It may shock denizens of the official demimonde that their persistent assault on the legal structure of bond indentures could be undone by something as obvious as private creditors acting in concert. Who could imagine?
Which brings us to Venezuela: pariah today, but perhaps not tomorrow. Whether the Biden administration offers Nicolás Maduro an amnesty, or whether the president is deposed by his generals, shares power with the opposition, or decamps to Rio, the odds are good that Venezuela makes a comeback to international capital markets.
Venezuela’s default is unique in recent history: a debtor that is asset-rich but cash-flow poor, wealthy but laid low by corruption and repression. A nation with vast human capital and sufficient assets to care for its people, fund infrastructure, and pay its debts in full. It took decades of criminal mismanagement to reduce the country to dire straits: the path to recovery can be short. Consider: the US increased oil production by 800,000 barrels per day over the past 12 months; by creating a hospitable environment for foreign direct investment (FDI), Venezuela could quickly ramp production by 1,000,000 barrels per day, and more.
FDI can provide only some of the investment Venezuela needs. To meet social needs and revive the broader economy, Venezuela must tap international capital markets. Before that can happen, the default on roughly $140bn of hard currency claims owed by sovereign and state-owned enterprises to foreign holders of defaulted bonds, arbitration awards, trade claims, and judgments must be resolved.
That’s where collective action comes in. Once Western liberal democracies give a new government their imprimatur, there’ll be a bum’s rush. The IMF will spew money without demanding accountability or defining clear, achievable goals. As in Argentina, IMF money will fill many of the wrong pockets. But the IMF, and its co-conspirators, will push hard for quick deals that are long on debt forgiveness but short on the reforms needed to restore Venezuela’s social and economic health.
Creditors will do well to engage — but not accede to formal negotiations until Venezuela’s path becomes clear. They should insist on seeing actual reformation of failed institutions (like the electoral commission and the courts), enactment of laws protecting private property and foreign investment, and reorganisation (or liquidation) of failed state-owned enterprises. Only once Venezuela’s future becomes less opaque can private creditors assess whether a new government is seriously committed to durable economic and institutional reforms — or whether the new team is simply making new promises as empty as the old.
One thing to bear in mind: there is risk for creditors. Venezuela has had a century-long love affair with corruption. The people in key government roles may change, but the place may not. Some will revile the idea of creditors seeking an active role — much less pushing for serious change — as uncharitable, lacking empathy. Far from it. No one can help but feel compassion for people who have been crushed by regimes that function more as crime families or narco-states than as governments. But it would be absurd for private creditors to continue to enable serial defaulters to perpetuate cycles of corruption and dysfunction. Unless there’s a new approach, that’s what will happen — as it has for far too long.
Make no mistake: for private creditors to harness and assert their intrinsic power in sovereign debt restructurings would be revolutionary — but offers a much better prospect than watching passively as another country’s problems are papered over. Perhaps surprisingly, sovereign debtors that do this hard work will benefit the most through reformation of failed institutions and renewed, reliable access to capital at lower cost.
Venezuela is a case study of how states fail. Perhaps in the near future it can demonstrate how they succeed.
Further reading:
— Venezuela’s long and winding debt restructuring road (FTAV)
— Taking stock of Venezuela’s economic crisis (FTAV)
— Venezuela’s debt resolution: recover the assets (FTAV)