In our Global Investment Themes for 2023, we wrote that ongoing sovereign debt restructurings seem to be taking longer than normal due to a common set of key issues, including, among other things, delays by the official sector (largely understood to be driven by China) in forming a creditor committee, providing financing assurances, and agreeing to restructuring terms.
We elaborated on the topic this week with specific reference to Sri Lanka and Zambia and highlighted how a recent G20 communique seemed to imply that China may have taken issue with the principle of seniority of MDB debt, which is a fundamental cornerstone of all Paris Club/IMF-backed restructurings, with World Bank President David Malpass adding that "Changes in China’s positions are critical" for more rapid progress in ongoing restructuring discussions.
Against this backdrop, Sri Lanka appears to be taking steps to prevent China from delaying its restructuring process, with Bloomberg reporting earlier this week that Sri Lanka is considering the introduction of a "Most Favored Creditor" (MFC) clause in its debt restructuring. Lee Buchheit and Mitu Gulati proposed this mechanism in a recent paper (and subsequently in the FT) as "a measure that the sovereign debtor can implement unilaterally without first seeking the consent of each creditor group" to break any logjam caused by "mutual suspicion among the three main creditor groups."
MFCs are explained in detail in those notes, but in short "...if ever [a debtor] pays or settles with a holdout creditor on better terms (for the creditor) than those agreed with the majority of its commercial lenders, the debtor will reopen the majority deal to give the same sweeter terms to everyone else." While MFCs do not legally forbid a borrower from granting more favourable terms to a specific creditor, "because such a reopening would be extraordinarily unlikely to happen, prospective holdouts are expected to deduce that their chances of extracting preferential terms are slim to none."
Indeed, there is precedent for some form of MFCs in sovereign bond restructurings in cases where bondholders had concerns over what commitments may be given to other creditors, including Argentina’s Rights Upon Future Offers (RUFO) clause in 2005 and in Belize’s 2013 restructuring related to the settlement of additional liabilities. However, previous sovereign MFCs have aimed at ensuring equal treatment among commercial creditors, not across groups of creditors, and have never specified the process to be followed if it is violated.
According to Buchheit and Gulati, "The only example of an MFC provision designed to operate across different creditor groups is the Paris Club’s comparable treatment clause," and this clause has never been formally enforced, with one study showing an average difference of over 20pp in the NPV reduction of official and private creditors in past restructurings.
As we recently explored in detail, Sri Lanka’s debt restructuring faces numerous complications and question marks, including if and how to treat domestic debt and SLDBs, how to treat the guaranteed debt of Sri Lanka Airlines, an ongoing lawsuit by a major holder of the ‘22s, a mixture of old and new CACs and other oddities in its bond documents, and the prominence of non-Paris Club creditors (which comprise 58% of bilateral debt, including 40% for China and 15% for India).
The use of an MFC clause in Sri Lanka’s restructuring could allow the process to move forward even if, after reaching an agreement with the Paris Club and private creditors, it is unable to secure a comparable agreement with non-Paris Club creditors like China and India. If successful, MFCs could prove an essential tool to prevent China from delaying the restructuring process and enable more timely restructurings than we have seen of late.
That said, while bondholders would likely be happy to agree to a deal that includes an MFC clause knowing that the deal will get reopened if any holdout creditors eventually get a more favourable deal, it's not guaranteed that the deals that are ultimately struck with the holdouts will be disclosed in enough detail to make such a judgement. It could also be a long time before a deal with holdouts is eventually struck if they would prefer to prolong the default rather than accept a comparable deal. Indeed, this is what happened in Argentina in reference to the RUFOs, which the government blamed for its inability to reach a deal with holdout creditors.
We expect an MFC clause could be included in bond documentation for new bonds, although it is unclear to us how they might be enacted in bilateral lending arrangements (perhaps under an MOU). Further, it is not clear exactly what form it would take, with Buchheit and Gulati outlining in their paper/article a number of refinements and clarifications that may be necessary to ensure that it is enforceable and applicable across creditors and enforceable. Nor is it clear how an MFC would interact with the IMF’s Lending Into Official Arrears (LIOA) policies, which may prevent the IMF from extending funding if a major official creditor has not provided financing assurances, thus delaying the restructuring even in the presence of an MFC clause.
In practice, however, the bar for financing assurances has been quite low in recent restructurings and the IMF has been liberal in its application of LIOA policies where adequate assurances have not been forthcoming. In Zambia, for example, the IMF Board approved its programme after what appeared to be only a vague acknowledgement that official creditors were willing to restructure Zambia’s debt, while in Suriname LIOA policies were applied to facilitate Board approval despite financing assurances from China and India that were “less specific than those provided by the Paris Club”.
Against this backdrop, it is possible (but not guaranteed) that the combination of an MFC clause and liberal application of the IMF’s LIOA policies can allow a restructuring to go forward against the wishes of a major non-Paris Club creditor. It is also worth noting that the MFC can be implemented without needing the agreement of all creditors, as the benefit to those participating in the restructuring is clear (ie it ensures that they will not be disadvantaged by moving early) and there are no changes needed to the legal documentation of the holdout creditors to make it effective.
While the feasibility of using MFCs to speed up sovereign debt restructurings is still open to question, their potential use in Sri Lanka could be an important innovation in the sovereign debt architecture. If implemented successfully, MFCs could partially address the challenges stemming from an increasingly diverse creditor mix by allowing restructuring agreements to be finalised with creditors even if one or more groups of creditors are holding out. If Sri Lanka successfully utilises MFCs in its restructuring, it could serve as a template for future restructurings and could be adopted in ongoing cases such as Suriname and Zambia that are stuck in the mud.
Sri Lanka’s debt restructuring explained, November 2022
Sri Lanka: Upgrade ‘22s to Hold on collapsed premium, August 2022
Sri Lanka: IMF talks mark beginning of long road, April 2022
Sri Lanka announces external debt restructuring, April 2022