Monday 16 January 2012

Greek CAC’s Devil’s Advocate (Advocatus Diaboli)

The practice of Devil’s advocate goes back many centuries. The origin of the term comes from the Canonization process of the Catholic Church. The church appoints a God’s advocate (Advocatus Dei) that argues in favour of the Canonization and a Devil’s Advocate who promotes the sceptical view. Most recently (2002), Christopher Hitchens played the Devil’s advocate in the Canonization of Mother Teresa. He, by the way, argued that she is fanatic, fundamentalist and a fraud who is responsible for more misery and deaths in India due to her stubbornness in promoting hardship and punishment often resulting in death rather than the emancipation of women.

Jumping forward 10 years, Greece is considering introducing Collective Action Clauses (CAC) in the Bonds under Greek law in order to force a higher participation in the PSI restructuring process. We have argued against this action repeatedly (see previous Notes, and posts). We present a hypothetical exchange between the Devil’s advocate (A.Diaboli, Bondholders) and God’s Advocate (A.Dei, Hellenic.Republic).

A.Dei: The Hellenic Republic has in its sovereign power the right to introduce CAC even though these do not currently exist in the Bonds. It is not a Credit event as it does not impair the value of the bonds.
A.Diaboli: The original bonds do not have this clause and any unilateral change of the bonds terms by the Hell.Republic that lowers the value of these bonds is a Credit Event. Academic studies have shown that the introduction of CAC’s into a Bond’s prospectus results in a higher yield demanded by investors especially for lower quality issuers such as Greece (See Eichengreen & Mody[1] 2000).  Furthermore, the future rights of the bondholders are adversely affected just by introducing them. For these reasons the introduction of the CAC impairs the bonds and as such should be considered to be an event of default.
A.Dei: The activation of the CAC’s is not a credit event as it is the bondholders and not the Hellenic Republic who demand it and not the issuer. Therefore provided the requisite majority is achieved the restructuring can proceed without a credit event.
A.Diaboli: ISDA rules are very strict. Any restructuring that is binding to bondholders is Credit event. See section 4.7 of their document[2]. Thus any activation of the CAC would result in restructuring and thus it would be an event of default.
A.Dei: Collective Action Clauses are binding for everyone and invoke the principle of burden sharing in a restructuring. Furthermore, they stop incalcitrant and malevolent bondholders from disrupting a fair and just solution for everyone involved. Many investors buy the Greek bonds with a view of suing the Republic and should be punished for it.
A.Diaboli: A.Dei is right in saying that the CAC facilitate the speedy and just resolution of a restructuring. However, when invoking the right of the majority, the principle of Good Faith must be observed[3]. In other words, one cannot just by having the majority impose a solution that is unjust and detrimental to some bondholders. The majority has the duty to consider the welfare of all the bondholders, not just their own. And this is exactly what is going on in the case of Hell.Republic. As it stands, the official sector is exempted from any PSI restructuring and the Greek banks would cover their losses by being recapitalised by the issuer. Similar assurances have been given to European Financial Institutions by European politicians. We thus have a situation, whereby, certain classes of investors (Official Sector ECB, Greek Banks etc) are indifferent to the restructuring losses.  This is by no means a just and equitable burden sharing. It looks as if their vote has been bought by the issuer.
Moreover, one can argue that there is collusion between some investors[4] and the issuer to defraud certain small class of investors by invoking the rights of the majority. If the introduction of the CAC by the Hell.Republic is done at the minimum of 50% (plus 1) rather than a supermajority of 75% or more that view would be reinforced.
Finally, punishing the investors is not an acceptable goal for the activation of CAC. As we have argued above, some investors escape unscathed from the restructuring while others take a big hit. This is blatant discrimination of investors. Additionally, the official sector (ECB) may be exempted from any CAC’s effectively subordinating every other bondholder to the Official sector which is again an event of Default.
A.Dei: The introduction of the CAC would be done under Greek law and we do not follow the American or other precedents. We are not bound by any previous rulings or assumed good faith practices.
A.Diaboli: Indeed that may be the case, but the Hell.Republic does not operate in vacuum. As a western modern state and a member of the European Union it has to behave accordingly. Failing to do so, would only damage the credibility of the country and give ammunition to those who demand its expulsion from the Union.

[1] Eichengreen & Mody, Would Collective Action Clauses Raise Borrowing Costs? An Update and Additional Results,
[2] (a) "Restructuring" means that, with respect to one or more Obligations and in relation to an aggregate amount of not less than the Default Requirement, any one or more of the following events occurs in a form that binds all holders of such Obligation, is agreed between the Reference Entity or a Governmental Authority and a sufficient number of holders of such Obligation to bind all holders of the Obligation or is announced (or otherwise decreed) by a Reference Entity or a Governmental Authority in a form that binds all holders of such Obligation, and such event is not expressly provided for under the terms of such Obligation in effect as of the later of (i) the Credit Event Backstop Date and (ii) the date as of which such Obligation is issued or incurred………

[3] “Power granted in an indenture to a majority of Bondholders to bind a minority must be exercised in good faith”. ABA Commentaries on Model Debenture (Sage 99 at US 341)

[4] See, Klein & Juhle, Majority Rules: Non Cash Bids and the reorganization sale. American Bankruptcy Law Journal, Vol.84, p.297-326.