Bankruptcy

Collective Action Clauses: Das Opium des Volkes

By Anna Gelpern

My Soviet roots manifest most acutely around New Year?s (a big holiday in the motherland), which must account for the urge to quote Marx apropos the European financial crisis.  Europe is the lead story of the 2010 Crisis Yearbook.  It holds the promise of radical legal innovation in financial crisis management:  it may yet become the birthplace of the first-ever sovereign bankruptcy regime, and the first-ever initiative to standardize sovereign bond contracts issued under the domestic laws of different states.  But for now, Europe is mired in CACology. 

In the absence of a sovereign bankruptcy regime, Collective Action Clauses (CACs) help solve coordination problems in sovereign bonds by binding all bondholders to the terms of a debt restructuring approved by the majority.  Some variants go farther to help map a path for debt renegotiation.  A promise to adopt CACs in all sovereign debt issued by EU member states figured prominently in statements by European leaders in November, and again by the European Council just a couple of weeks ago.  Beginning in 2013, CACs would be adopted, and could be used ?case by case? to facilitate restructuring of unsustainable government debts, and thereby share the burden of crisis response with the private sector, eliminating the need for bailouts.  CACs are part of the plan for a new European Stability Mechanism, which would replace the temporary European Financial Stability Facility and the European Financial Stabilization Mechanism, established earlier this year for three years.

As a general matter, CACs are a very good thing, as is the idea of harmonizing the domestic law debt of member states to include some form of debt restructuring support.  Sovereign bankruptcy is more complicated; fair coverage requires a separate post.  Even so, CACs? European revival is puzzling.  Unlike the last two campaigns to include CACs in foreign sovereign bonds in the 1990s and early 2000s, today?s initiative does not point to coordination problems.  Most of the sovereign bonds at issue either already have CACs or include other features that make restructuring relatively straightforward.  Much of the European debt problem outside Greece stems from private sector debts, which can be restructured in bankruptcy or its analogues.  Moreover, standardized CACs on the Group of Ten model referenced in the EU statements are a hard fit for domestic law bonds, whose documentation is very idiosyncratic.

With the historic crisis still spreading, why lead with such an ill-fitting remedy?  Mitu Gulati and I noodle this question in our introduction to the forthcoming Law & Contemporary Problems volume on the Modern History of Sovereign Debt.  Looking back to CACs? policy debut in 1996 and return in 2002, which led to their widespread adoption in foreign sovereign bonds,  we get the nagging sense that CACs have always been something of a diversion.  Politicians who must explain unpopular bailouts to the angry public want to be seen as solving the problem that led to the bailout.  They want to look the public in the eye and promise no more bailouts.  But the real problems underlying any big financial crisis are complicated and often intractable, which is why crises always return.  Real solutions require alienating powerful constituencies, spending tax money, and reducing the availability of credit, among other unpopular measures.  When real solutions are out of reach, officials are tempted to reframe the problem.  Creditor coordination can be fixed with CACs; sovereign insolvency, bank under-capitalization, interdependence and interconnectedness cannot.

The fact that no one has identified the creditor coordination problems blocking European bond restructuring, nor their roots in contract terms, is telling.  After the official drive of the 1990s and early 2000s, CACs have acquired such a powerful symbolic meaning as a market-friendly answer to both bailouts and treaty-based sovereign bankruptcy, that collective action problems are no longer needed to invoke them.

If CACs are good, what is the harm?  None but spending precious time on tertiary business and misleading the public about what it would take to solve the real problem.  But then again, after a decade of studying CACs as we have, anyone would get cynical.

Full post as published by Credit Slips on December 31, 2010 (boomark / email).