Perfect Market Puzzles:
Five Observations from the World of Sovereign Debt
BY LAW CENTER PROFESSORS WILLIAM BRATTON AND MITU GULATI

An earlier version of this article was published in the Economic and Political Weekly (India) in June 2002.

Economists like to claim that free markets solve economic and social problems without the need for government interference. Although we take these claims seriously, we sometimes respond to them with skepticism. For example, the story that market forces will operate to eliminate labor market discrimination on the basis of race and gender always has had a ring of implausibility. However neatly this economic theory is articulated, the claim makes no sense when viewed through the lens of everyday reality. For an interesting comparison, consider the claim that market scrutiny and the pressure from that scrutiny –pressure especially intense on the largest and most widely traded companies – will ensure that publicly traded companies make full and fair disclosure of all information needed by security holders. At one time this claim seemed plausible. But the troubles of Enron, Global Crossing, Tyco, and WorldCom now make this claim laughable. Our story here is about another market that supposedly approximates the free marketer’s paradigm of perfection – a market where assumptions about fully informed parties, efficient contract negotiation, efficient pricing, and instantaneous adjustment to new information ought to hold good, eliminating any need for regulation. This is the market for sovereign bonds.
     The parties to contracts in this market, national governments on the one hand and investors in the bond markets on the other, are represented by the fanciest investment banks and lawyers in New York and London (the venues where the vast majority of sovereign bonds are issued). These parties are as sophisticated as contracting parties can be. If ever there was a market where contract terms should evolve so as to provide efficient regulation for all future events, where all parties should be fully informed, and where traded securities should be priced accurately and should adjust to new information without friction, this ought to be it.

Having burned their fingers badly on direct sovereign lending, the banks largely exited the business in the late 1980s and 1990s….The bulk of sovereign borrowing for the past 20 years has been effectuated through underwritten public offerings…. Defaults inevitably occurred, with a steady stream of countries failing to pay over the past few years.

     Recent events, however, have considerably shaken our faith in this market. Here we list five manifest shortcomings in the operation of the sovereign debt market, matters which should cause even the most ardent of free marketers to question their faith. First, however, a short primer for those readers who have not been following developments in this world.
     In the early 20th century, sovereigns borrowed in public bond markets, where small investors joined big institutions as lenders. Decades of sovereign default drove out the small investors. By the 1970s and 1980s, sovereigns did most of their borrowing from big banks like Chase, Chemical, and Citicorp. As many remember vividly, there followed a number of spectacular defaults by sovereign bank borrowers. The international financial community spent years renegotiating and restructuring that debt. There was lots of handwringing by the banks as they resisted writing down their loans. But eventually the restructuring deals were done. In an apparent triumph of spontaneous order, each bank agreed to write down its loans so as to facilitate new lending and eventual economic recovery for the nations in default. Charity was not a factor, however. Banks are long-term players on the world financial stage. They do repeated business with their national borrowers and with one another. They generally see it to be in their interest to cooperate with compositions, even as they complain.
     Having burned their fingers badly on direct sovereign lending, the banks largely exited the business in the late 1980s and 1990s. As a result, sovereign borrowers returned to the public bond markets, where the bad experiences of decades before had been forgotten. The bulk of sovereign borrowing for the past 20 years has been effectuated through underwritten public offerings. Depending on the transaction, the bonds have been purchased by an array of investment institutions and individual investors. And all was fine for a while. But defaults inevitably occurred, with a steady stream of countries failing to pay over the past few years, among them the Ukraine, Pakistan, and Ecuador. The largest and biggest default, of course, came from Argentina two years ago.
     These defaults present a problem not present in the 1970s and 1980s, when restructuring negotiations involved small numbers of participants from inside the club-like world of international finance. Today, thousands of bondholders, many holding small stakes, have to be present at the negotiating table, leading to a monumental coordination problem. Some of them are difficult to contact. Others simply may not be interested in negotiating, preferring to hold out and see if higher returns flow to those who refuse to cooperate.
     Now, a rational economic observer at this point might dismiss the problem as follows: “Coordination and holdout problems can be solved through advance planning at the contracting stage. So just check the bond contracts. The investment bankers and lawyers who drafted them will have provided for these eventualities. The parties will have agreed to install a trustee or other elected representative who can negotiate and make maximizing decisions on behalf of all the bondholders.” This brings us to puzzle number one.
     Puzzle number one is that our supposedly fully informed and rational lawyers and investment bankers did not contract for coordination in the eventuality of a sovereign default. This could not have been an oversight, for they could hardly say the contingency did not occur to them. In fact, the United States-issued contracts allow every single bondholder to sue individually and require unanimous approval from all the bondholders for any renegotiation of the principal, interest, and payment dates on the bonds. With large numbers of dispersed bondholders, this makes renegotiation well nigh impossible. And this is not merely a problem of coordinating large numbers of holders. At least some of these bondholders loudly announce their intent to hold out. That is, they refuse to renegotiate unless they are paid a premium above what the others are being offered. A significant number of hold-outs makes it impossible to conclude a restructuring, even with a manageable number of bondholders anda general view that the bondholders would be better off as a group if the restructuring succeeded. Why would bond contracts drafted in the world’s most sophisticated marketplace invite this result?
     Now, you well might ask whether we can explain this situation in terms of the lenders’ interests. After all, the lenders might have sought to make renegotiation difficult so as to deter the sovereign from any thoughts of ever declaring a default (economists call this “renegotiation proofing”), or in the event of a default, from seeking to shift loss from domestic constituents to foreign bond-holders. In this view, the contracts merely reflect the expectations of the parties. But reflection causes one to question whether such expectations follow from a rational analysis of the case. Economic discussions of efficient contracting presuppose the availability of law courts and judges in which renegotiation proof contracts can be enforced. With sovereign debt such a venue is hard to find; the best a bond-holder can do is attach sovereign assets sited abroad. For the group, coordination and compromise will tend to dominate as a rational strategy. If these contracts are rational, then they follow the rationality of the players in a prisoner’s dilemma.

A significant number of hold-outs makes it impossible to conclude a restructuring, even with a manageable number of bondholders and a general view that the bondholders would be better off as a group if the restructuring succeeded.Why would bond contracts drafted in the world’s most sophisticated marketplace invite this result?

     The failure to follow a better strategy seems more likely to be the result of inadvertence. Ask any one of the bond lawyers who drafted these contracts –and we have asked many: the dirty truth is that the language of these U.S.-issued sovereign bond contracts was essentially copied from those of the U.S. domestic bond contracts used by corporations. The lawyers and bankers drafting the sovereign contract failed to realize (or to confront the fact) that requiring unanimous approval for alterations in the domestic context does not create a serious coordination problem because U.S. corporations, unlike sovereigns, can declare bankruptcy and avail themselves of the protection of a court that can force non-consenting bondholders to agree to a reasonable renegotiation plan.
     For those who find this story implausible, it is illustrative to look at sovereign bond contracts that are issued in London (often for a sovereign that also borrows in New York). These contracts allow for modifications of key terms with only majority approval (this also turns out to be the practice with domestic corporate bonds in the United Kingdom). And there are at least a couple of academic papers that fail to find any meaningful interest rate spread that would justify the different contracting practices in London and New York (although this limited body of empirical study should not be deemed conclusive).
     Puzzle number two has to do with what happened once everyone saw the coordination problem held out by New York-issued bond contracts. In this sophisticated market, one would think that once the players figured out the problem, they would quickly revise their contract forms so as to avoid the problem in future transactions (especially when they all seem to agree on the need to rewrite the contracts). Wrong. Thus far, little has happened. A number of countries (including Mexico, Brazil, Uruguay, and South Africa) finally attempted in 2003 to move to CACs [collective action clauses] in New York-based transactions. But, for the most part, New York-issued contracts are drafted with the same old unanimity language. To ask lawyers about the reason for this is to hear of “drafting inertia.” One would have thought drafting inertia to be the exclusive provenance of legislatures, a malaise unthinkable in the highly creative, fast-moving, instantaneously adjusting, fully informed, and well-paid markets of global finance. Yet drafting inertia has persisted despite repeated academic interventions and official-sector exhortations (from the G-7, G-10, IMF, the Bank of England, and on and on) about the need to revise the language in the New York contracts.
     Now, even if there is drafting inertia and even if the terms initially were copied from corporate bond contracts without much thought, one would think that the lawyers and bankers would at least know the meaning of all the terms in their contracts. Once again, the answer is no.
     Puzzle number three is that no one seems to know the meaning of crucial terms in these contracts. Or, to put it more mildly (albeit less accurately), there is significant disagreement about the meaning of these terms. For example, almost every sovereign bond contract contains what is called the “pari passu” clause. In the corporate context, this term has a well-understood meaning: in the event of insolvency, lenders who are pari passu have equal priority of payment, one lender may not be paid ahead of another, and any payments should be made pro rata across an equal ranking class of lenders. But, because sovereign debt does not replicate the priority structure of corporate debt, and because sovereign insolvencies work very differently, no one has a clue as to what this term means in the sovereign context. It appears that each generation of drafters has simply copied the term from the previous generation’s bond documents, assuming that it must do something useful and never pausing to provide explication. We now are forced to try to deduce logically what the term must mean, with different interpreters posing competing theories. Not knowing what a crucial term means –especially a term found in every contract – is not exactly our ideal of an efficiently evolving financial contract. Nor does such a contract provide a basis for an efficient trading market which prices every term accurately. There can there be no accurate price for a contract containing material terms that no one really understands.

“Drafting inertia” has persisted despite repeated academic interventions and official-sector exhortations (from the G-7, G-10, IMF, the Bank of England, and on and on) about the need to revise the language in the New York contracts.

     Puzzle number four has to do with solutions. Two proposed strategies for solving the sovereign debt crisis dominate today’s landscape. The first asks for very little. Under this, we explain to the folks on Wall Street why they have irrational terms in their contracts and stand back and wait for them to alter the terms. The second, in contrast, calls for a heroic response among the nations. Under this, we set up an international bankruptcy court akin to those set up in industrialized countries for their distressed corporate debtors. As things stand, neither strategy has produced beneficial results. The lecture called for by the first has been made but very little has changed. The second, which calls for unprecedented cooperation among rich and poor countries, remains visionary. Although the IMF has put forward a sovereign bankruptcy proposal, it has backed away from aggressive advocacy of it in recent months.
     Meanwhile, it might be interesting to know what strategies are employed when distressed corporate borrowers whose debt contracts contain unanimity clauses try to effect out-of-court restructurings with their lenders. Yes, these corporate borrowers can declare bankruptcy. But bankruptcy is an expensive proposition and managers of companies try to avoid it because they usually end up losing their jobs in bankruptcy reorganization. It stands to reason then that private corporations and their lawyers probably have figured out ways around the unanimity provisions.
     It turns out that they have indeed. Lawyers for distressed U.S. corporations have successfully employed two strategies: (a) exit consents (which involve threatening to alter non-essential terms of a bond contract – which generally require only majority approval – unless the recalcitrant bondholders agree to the proposed revisions) and (b) class actions (a procedural mechanism designed in part to solve precisely the kind of coordination and hold-out problems involved in a sovereign default). Lengthy articles have been published on both of these approaches during the past 20 years. Yet, the supposedly sophisticated players in the sovereign markets have appeared to be largely unaware of these alternatives. Only in recent months has this situation begun to change, with class actions filed against Argentina and the use of exit consents by Uruguay. But, once again, movement up the learning curve by these supposedly sophisticated parties has been markedly slow.
     Puzzle number five concerns the strategy that seems to have found favor with the U.S. Treasury and, therefore, is the one being taken most seriously. (The IMF’s proposal for an international bankruptcy regime was promptly shot down by the U.S. Treasury’s John Taylor upon its announcement in April 2002.) The Treasury has signed on to the first strategy described above: We should “persuade” the lenders and borrowers in the sovereign market to alter their contracting practices so as to make the bonds easier to renegotiate. As noted earlier, such jawboning has not worked up to now. Recognizing this, current Washington policy talk suggests that the private-sector gurus will have to be induced to redraft the contracts by a combination of carrots and sticks. The carrot will be a condition to future IMF and other official-sector bailouts – these will be available only for those countries that have issued bonds that allow for non-unanimous modification. Alternatively, the IMF’s proposal for a bankruptcy court amounted to a stick of sorts. It was hoped that the fear and loathing it inspired in the international financial community of itself would move them out of their “drafting inertia.”

We may be unlikely to see a court in a financial center imposing strong intercreditor duties in the sovereign context.The puzzle, however, is that no one seems to have even tried to get a handle on the probabilities through a sustained examination of the applicable debtor-creditor jurisprudence, even as billions of dollars of claims pile up on the table.

     The fifth puzzle is not, however, that this is the solution that has found favor in Washington – although there is an irony there, what with a Republican administration full of ardent free marketers sitting back and telling Wall Street how to draft its bond contracts. The puzzle has to do with the majority amendment regime Wall Street is being told to adopt. Nobody seems to have much in the way of idea as to the nature of the law that would apply to compositions reached under majority-amendment contracts.
     Contract terms have value only to the extent that a court is willing and able to enforce them. Whether a particular contractual term will be effective to produce a certain outcome, therefore, depends on whether the relevant court will be willing to interpret the contract in a way that mandates that outcome. Recall now that the primary barrier to effectuating sovereign restructurings under today’s contracts is that these contracts call for unanimous approval before any of the bond terms can be changed. Recall also that the solution that has found favor is that these contracts be altered so as to allow modification by a majority or super-majority of the bonds.
     Two key assumptions about the law are being made here. The first is that the unanimity requirement in the existing contracts is absolute, i.e., that a court will protect a bondholder who unreasonably withholds her consent to a restructuring solely in order to extract a bonus payment for herself. The second, and related, assumption is that once we have majority or supermajority amendment clauses, restructuring will be a simple matter of persuading the majority or the supermajority of the need to accept less than the face amount on the bonds, and that a court will not take seriously a minority bondholder’s complaint that the amendment was unfair and should be stopped. In short, the assumption that has been made is that there are no inter-creditor duties, either those running from a minority to the majority or vice versa. But do we know that? That assumption certainly holds true in the corporate context in the U.S., where, outside of bankruptcy, the law of the jungle prevails between debtors and creditors and within groups of creditors. But creditor duties in the corporate context are articulated in the U.S. in the shadow of a bankruptcy law holding out exacting intercreditor duties; given the bankruptcy alternative, there exists no crying need for significant intercreditor duties in domestic common law.
     It is not at all clear to us, however, that the same thing follows for intercred-itor duties in the sovereign context in the absence of bankruptcy. As best we can tell, there is a negligible amount of law on the matter, and a court deciding the matter would essentially be writing on a blank slate. It is possible, then, that even a U.S. court will say that the context of sovereigns that cannot go bankrupt is one that calls for strong intercreditor duties. That, in turn, would mean two things. First, that the courts might be willing to step in to protect a sovereign and its majority creditors from an unreasonable hold-out. Put differently, there may not be such a big problem with the unanimity clause in sovereign bonds after all. And, second, that the courts might also be inclined to step in and scrutinize a restructuring where a minority claims the deal to have been forced down its throat by an unreasonable or self-interested majority. Put differently, the solution of moving to majority or supermajority approval for restructurings may not be quite so easy to implement as seems to be the general assumption. Now, we may be unlikely to see a court in a financial center imposing strong intercreditor duties in the sovereign context. The puzzle, however, is that no one seems to have even tried to get a handle on the probabilities through a sustained examination of the applicable debtor-creditor jurisprudence, even as billions of dollars of claims pile up on the table.
     With the problem of sovereign debt, everyone seems to assume that someone else, often referred to as “the market,” has figured out the solution. They assume that if there were a problem it will have been pointed out, and if there were a solution it will have been implemented. But even in the face of mounting billions in default, and growing coordination problems, it looks to us as if little has occurred. The mechanism of the invisible hand is magical indeed –when it operates at all. But its operation is not safe to assume, not even under the best possible set of conditions.