Thursday 29 December 2011

Collective Action Clause, Ρῆτρες Συλλογικῆς Δράσης

Collective Action Clauses (CAC’s henceforth) or Majority Action Clause have a long and varied history. According to Buchheit & Gulati[1] they were first introduced in English law by Palmer (1879). Their introduction served and serves a very real purpose and need. That of facilitating the restructuring or the amendment the (T)erms & (C)onditions of a Bond by the majority of Noteholders and to avoid rogue or malevolent holders of bonds holding at ransom both the debtor and other creditors.  What are CAC’s (see Appendix for an example) and what purpose do they serve?  Let me start with an example of how it might work.

Suppose that ACME a company that manufactures futuristic technology gadgets finds itself in the position of having a severe cashflow problem as one of its major clients Mr W.E.Coyote has not paid in time. ACME is unable to pay its bond liabilities at the agreed time. Consider further that most bondholders believe, after careful analysis of ACME’s product range, that the main business is sound and given time and perhaps some reorganization of the company’s management and client focus ACME would thrive and pay in full its bond liabilities. All that it needs is to amend some of the T&C of the bond, perhaps extend the maturity or move some coupons in the future and ACME would survive. One bondholder, Mrs R.Runner for reasons of personal benefit or other, things differently. When ACME got into trouble Mrs Runner bought some of the bonds at discount with a view to either force ACME into liquidation or force a management change or simply to extract more money. Mrs Runner can do so since ACME bonds need the consent of 100% of Noteholders as there are no CAC’s that allow for the will of the majority to prevail. If on the other hand, ACME bonds included right from the start CAC’s specifying that a 75% majority is binding for all bondholders Mrs Runner would have needed at least 25% of the outstanding ACME bonds to see her sinister plans materialize.

As always, however, there is another side to the ACME story. It could be that the real villain is ACME and the victim is the unsuspecting small bondholder. ACME purposefully, introduced (at the start) CAC’s with a low majority threshold, say 50% (simple majority) with a view to make non-payment or restructuring fast and easy. ACME colluded with some bondholders to haircut the bond’s principal by 50%. Then ACME found some other way to compensate (recapitalize or sweeten) its friendly creditors. 

Thus, CAC’s have two sides. Striking a balance between the real need to restructure a company and with the moral hazard it introduces is a fine art. Ultimately, any dispute in the motives would have to be resolved by courts. In fact, there have been cases where the majority has been overturned as it was not deemed to serve the interests of all bondholders. This means that even though CAC’s allow for the majority view to prevail, the minority bondholders cannot be ignored completely. After all, the original bond documentation contains an “unconditional promise to pay”. 

One argument against the introduction of CAC’s in the bond documentation has to do with price and liquidity. Studies have concluded that the introduction of CAC’s in less creditworthy countries (lower rating) have an adverse effect on the price and liquidity. Namely, creditors demand a higher yield as they view the CAC’s from the moral hazard point of view. For borrowers of high rating CAC’s are viewed as a safety feature. 

Europe and the Greek Case

One has to note that while in the case of corporates all countries have laws dealing with bankruptcy (Chapter 11 in US etc) the equivalent for sovereigns does not exist. There have been various attempts by IMF and others to formalize the process with various degrees of success. Introducing CAC’s is one way to ease and facilitate the speedy resolution of debt restructurings. It is for this reason the European Finance Committee[2] (EFC) in Europe welcome in April 2003 the implementation of CAC[3] in European Bond issuance. The Chairman of that committee was none other than Prof. Christodoulakis the then Greek Finance minister. 

It may not come as a surprise that Greece never implemented CAC’s in its domestic bond issuance despite the apparent endorsement of the Greek Finance minister.  If it had done so back in 2003 things would be very-very different now for Greece; for the better. In fact, Greece is the only country alongside Italy that it did NOT implement CAC’s in their domestic bond issuance. Italy’s formal claim was that it would affect the price and liquidity of its bonds. We do not know the reasons of the Greek non-compliance (after all the Chairman of the EFC was Greek!).

PSI and Greek Bonds
One can divide the Greek debt into two classes; those that are issued under Greek law (ISIN starts with GR….) and those that are issued under foreign law. Before the Greek bailout and the bilateral loans to Greece, around 90% of the Greek debt was under Greek law and jurisdiction. This percentage together with the advantage it conveyed to Greece is been eroded, as all the bailout loans are under English law.  In fact, most of the Greek foreign law bonds are under English law and all of them contain some form of CAC’s. Some[4] require a 2/3 (66 2/3) majority while others[5] have a 75%. Even though restructuring these bonds is easier as they contain CAC’s they also offer much higher protection to the bond holders and as such they are traded at a premium to the Greek domestic bonds. This is because they also contain “Negative pledge” and “moratorium” clauses and also because any dispute would be decided in London and not in Athens courts. In fact some contain very poisonous clauses and it is a source of puzzlement why the Greek government has not attempted to obtain the requisite majority to either change these clauses or destroy the bonds.

For the Greek domestic bonds things are different. As mentioned above the Greek domestic bonds do not contain CAC’s and thus any restructuring that aims to avoid a Credit Event (Default) would require the consent of all bondholders. It is for this reason that the PSI was declared to be a voluntary proposal. Trying to secure a high participation was left to the gentle persuasion of politics and incentives. For an analysis of the current state of the PSI read “Should Santa bring PSI to the Greeks” (and in Greek here). 

Should Greece introduce CAC’s to force PSI?
As it turned out, however, bondholders were not adequately incentivized to participate in the voluntary loss of more than half of their investment. In fact, the largest bondholder, the ECB, has flatly rejected any talk of participating in the PSI. Other bondholders see that as an opportunity to join the free ride (See “The thrills and joys of free-riding”). 

It comes as no surprise that according to Greek press reports the Greek government is considering introducing CAC’s to force the holdouts to participate in the PSI. 

Here we ask the question: “Is it prudent for Greece to do so? What are the pros and cons of such an action?
Let’s assume that Greece manages to come to some form of common ground with the IIF (representing the bondholders) and a bond swap is on offer. Namely, holders of the Greek bonds would tender their holdings and in return they would get some New Greek bonds and perhaps some cash. Assume further that only 65% participation is achieved. Greece being a sovereign state has the power to legislate at that point, that once the offer has been accepted by 65% it is binding for the rest 35%. It can further legislate that small (up to 100,000) private bondholders are immune. Greece certainly has the power to do it, but doing so is an event of default. This is because Greece changes unilaterally the Terms of already existing bonds to the detriment of the bondholders. This is where things get more complicated. Under the voluntary offer Greece would assume the status of “Selective Default” which is not really a default as it describes the period between making an offer and the acceptance of this offer. Now, however, the Greek government has caused a full blown default. It goes without saying that CDS’s would be activated, but this is only a political concern and not an economic. The outstanding net CDS volume is far too low to have any impact (around 3billion). The objection to the CDS comes mainly from ignorant or populist politicians. The main problem would come from Greece being placed under default and the litigation it would trigger. Furthermore it cannot discriminate in favour of the ECB. The ECB would have to oblige to the will of the Greek CACs. It also sets a very dangerous and unwelcome precedence for all bondholders of European debt. Holders of debt of third world countries factor in such a behavior when it comes to investing in their bonds. They do not expect this kind of behavior from European Union country. This would alter the perceptions, pricing and dynamics of European debt for many years. If on top, Greece discriminates positively against the official sector (ECB) it would deal a further blow to the credibility of the EU and its practices. Last but not least, Greece would enter a period of prolonged legal battles with disgruntled bondholders. This is paradise for the law firms who advice Greece as it would mean many years of high legal fees. Despite the fact that it would be difficult for bondholders to attach any Greek assets to their claims they can make life for the Greek government very difficult and possibly prohibit Greece from entering the international capital markets for many years unless Greece settles their claims.
In summary, introducing CAC’s to force the PSI would: 
  • Be a credit default event. One cannot see the logic of having a credit event just for participation in the PSI. It is like using a sledgehammer to kill a fly. If Greece decides to go down that route, they might as well legislate that all bonds become zero coupon. 
  •   Greece would have to have the financial support and consent of the ECB and EU. Otherwise it would not survive the financial repercussions of an event of default.
  •  Trigger CDS 
  • ECB would have to take losses and possibly go bankrupt unless the Greek government positively discriminates the official sector and possibly small private owners. This would be a particularly bad precedent for Europe and would for sure be challenged by other bondholders.
  •  Greece would engage into hard and long legal battles as bondholders challenge this.Reputation of Greece as a debtor would be severely affected because of its behavior.
  •  Reputation of EU would also be affected as this is not what creditors expect from a member of the Union. 
  • Greece would set a very bad precedent for other European countries. The market would price accordingly other peripheral bonds. 
  • Greece would still need to borrow money to pay the coupons of the new PSI bonds. Estimates vary between 6 and 8 billion. As Greece is running a primary deficit it would need to access the markets or turn to the IMF/EU once more.
It is thus very hard to find anything positive to say about such an action. In fact the only beneficiaries of such an action would be the lawyers that advise Greece and would be defending Greece for many years with high fees. It would be a gross mistake for Greece and Europe to follow that path.  Let us hope that the press reports are just empty threats aimed at naïve bondholders because the serious ones are already honing their battle axes and Greece is no match for them.

Appendix A. Example of CAC from Greek Bond XS0357333029
The Agency Agreement contains provisions for convening meetings of Noteholders to consider matters affecting their interests, including modification by Extraordinary Resolution of these Terms and Conditions or the provisions of the Agency Agreement. Such a meeting may be convened by the Republic and shall be convened by the Republic at any time upon the request in writing of the holder or holders of ten per cent. or more in principal amount of the Notes for the time being outstanding. The quorum for any meeting convened to consider an Extraordinary Resolution shall be one or more persons holding or representing not less than 66 2/3 per cent. of the aggregate principal amount of the Notes for the time being outstanding, or 25 per cent. of the aggregate principal amount of the Notes for the time being outstanding at any adjourned meeting. However, at any meeting, the business of which is to: (i) change the due date for the payment of the principal, premium (if any) or any installment of interest on the Notes;
(ii) reduce or cancel the principal amount or redemption price or premium (if any) of the Notes;
(iii) reduce the portion of the principal amount which is payable upon acceleration
 f the maturity of the Notes;
(iv) reduce the interest rate on the Notes or any premium payable upon redemption of the Notes;
(v) change the currency in which interest, premium (if any) or principal will be paid or the places at which interest, premium (if any) or principal of Notes is payable;
(vi) shorten the period during which the Republic is not permitted to redeem Notes, or permit the Republic to redeem Notes if, prior to such action, the Republic is not permitted to do so;
(vii) reduce the proportion of the principal amount of the Notes whose vote or consent is necessary to modify, amend or supplement the Agency Agreement or the Terms and Conditions of the Notes;
(viii) reduce the proportion of the principal amount of the Notes whose vote or consent is necessary to make, take or give any request, demand, authorisation, direction, notice, consent, waiver or other action provided to be made in the Agency Agreement or the Terms and Conditions of the Notes;
(ix) change the obligation of the Republic to pay additional amounts with respect to the Notes;
(x) change this definition, the definition of “outstanding” contained in the Agency Agreement or the definition of “Written Resolution” set out below;
(xi) change the governing law provision of the Notes;
(xii) change the courts to the jurisdiction of which the Republic has submitted, its obligation under the Agency Agreement or the Terms and Conditions of the Notes to appoint and maintain an agent for service of process or the waiver of immunity in respect of actions or proceedings brought by any holder based upon a Note; or
(xiii) appoint a committee to represent Noteholders after an event of default occurs; (each a “Reserved Matter”), the necessary quorum will be one or more persons holding or representing not less than 75 per cent. of the aggregate principal amount of the Notes for the time being outstanding or not less than 50 per cent. of the aggregate principal amount of the Notes for the time being outstanding at any adjourned meeting. Resolutions may be duly passed as an Extraordinary Resolution at any meeting of the Noteholders or by Written Resolution and will be binding on all the Noteholders (whether or not they are present at such meeting and whether or not they may sign the Written Resolution) and on all Couponholders. An “Extraordinary Resolution” means a resolution passed at a meeting of the Noteholders duly convened and held in accordance with the provisions above by or on behalf of the holders of: (i) in the case of a Reserved Matter, at least 75 per cent. Of the aggregate principal amount of the Notes for the time being outstanding or at least 50 per cent. at any adjourned meeting of aggregate principal amount of the Notes for the time being outstanding, or (ii) in the case of a matter other than a Reserved Matter, at least 66 2/3 per cent. of the aggregate principal amount of the Notes for the time being outstanding or at least 25 per cent. at any adjourned meeting of the aggregate principal amount of the Notes for the time being outstanding. A “Written Resolution” means a resolution in writing signed by or on behalf of the holders of: (i) in the case of a Reserved Matter, at least 75 per cent. of the aggregate principal amount of the Notes for the time being outstanding, or (ii) in the case of a matter other than a Reserved Matter, at least 66 2/3 per cent. of the aggregate principal amount of the Notes for the time being outstanding. Any Written Resolution may be contained in one document or several documents in the same form, each signed by or on behalf of one or more Noteholders.
The Republic and the Agent may, without the vote or consent of any holder of the Notes, amend the Agency Agreement or the Notes for the purpose of: (i) adding to Republic’s covenants for the benefit of the holders of the Notes; or
(ii) surrendering any right or power conferred upon the Republic; or
(iii) securing the Notes; or
(iv) curing any ambiguity or curing, correcting or supplementing any defective provision in the Notes or the Agency Agreement; or
(v) amending the Agency Agreement or any of the Notes in any manner which
the Republic and the Agent may determine and which is not inconsistent with the Notes and does not in the opinion of the Republic adversely affect the interest of any holder of the Notes; or
(vi) correcting in the opinion of the Republic a manifest error of a formal, minor or technical nature; or
(vii) complying with mandatory provisions of law or any other modification provided that such modification is not in the opinion of the Republic materially prejudicial to the interests of the Holders. Any such modification, waiver or authorisation shall be binding on the Noteholders and any such modification unless the Agent otherwise requires, shall be notified by the Agent to the Noteholders as soon as practicable thereafter. For the purposes of (i) ascertaining the right to attend and vote at any meeting of Noteholders, (ii) Condition 10 (Meetings of Noteholders and Modification) of the Offering Circular and Schedule 3 of the Agency Agreement (Provisions for Meetings of Noteholders) and (iii) Condition 7 (Events of Default) and for purposes of determining whether the required percentage of holders of the Notes are present at a meeting for quorum purposes, or has consented to or voted in favour of any request,
demand, authorisation, direction, notice, consent, waiver, amendment, modification or supplement to the Notes or the Agency Agreement, or whether the required percentage of holders has delivered a notice of acceleration of the Notes, any Notes that the Republic owns or controls directly or indirectly will be disregarded and deemed not to be outstanding. For this purpose, Notes owned, directly or indirectly, by the Bank of Greece or any of the Republic’s local authorities and other local authorities’ entities will not be regarded as, or deemed to be, owned or controlled, directly or indirectly by the Republic. “Control” means the power, directly or indirectly, through the ownership of voting securities or other ownership interests or otherwise, to direct the management of or elect or appoint a majority of the board of directors or other persons performing similar functions in lieu of, or in addition to, the board of directors of a corporation, trust, financial institution or other entity. Before any request is made or notice is delivered or Written Resolution is signed by any Noteholder in accordance with the provisions of this Condition 10 or Condition 7, the relevant Noteholder must deposit its Notes with the Paying Agent and obtain two copies of an acknowledgment of receipt (an “Acknowledgment”) signed and dated by the Paying Agent and certifying the nominal amount of Notes so deposited. Any request so made, notice so given or Written Resolution so signed by any Noteholder must be accompanied by an Acknowledgment issued to the Noteholder. Notes so deposited will not be released until the earlier of (i) the thirtieth day after the date of deposit and (ii) the request, notice or Written Resolution becoming effective in accordance with these Terms and Conditions, and will only be released against surrender of a relevant Acknowledgment.

[1] Lee C. Buchheit,G. Mitu Gulati, 2002, SOVEREIGN BONDS AND THE COLLECTIVE WILL
[2] ECFIN/CEFCPE(2004)REP/50483 final
[3] In 2002 the G10 working group adopted this and issued model clauses
[4] Those issued before 2004.
[5] If issued after 2004.