While the COVID-19 pandemic continues to pose unprecedented challenges to countries worldwide, the impact is even more critical on developing countries that already face high debt burdens. Developing countries—including many African nations—will require significant liquidity and financing support to deal with the pandemic, which the IMF estimates may cost at least US$2.5 trillion. In the face of such seemingly insurmountable fiscal challenges, a number of supranational agencies and private bodies are looking to provide potential solutions and give these countries the fiscal space to deal with their looming problems.

The G20 nations announced a debt service suspension initiative (DSSI) in April 2020 in response to a COVID-19 "call to action" from the World Bank and the IMF. The DSSI supports a net present value (NPV)-neutral, time-bound suspension of principal and interest payments for eligible countries that make a formal request for debt relief from their official bilateral creditors, and it encourages private creditors to participate on comparable terms. Since the announcement, many market participants have come forward with alternative or supplemental proposals to expand the initiative, with a particular focus on private sector involvement.

Although these suggested solutions are well intentioned, countries should carefully consider the impact on all of their financing arrangements before availing themselves of various available debt relief options. As momentum increases to support countries facing real economic challenges, there are important practicalities and legal impediments to implementing any form of debt relief program.

DOWN THE RABBIT HOLE

"Alice started to her feet, for it flashed across her mind that she had never before seen a rabbit with either a waistcoat-pocket, or a watch to take out of it, and burning with curiosity, she ran across the field after it, and fortunately was just in time to see it pop down a large rabbit-hole under the hedge. In another moment down went Alice after it, never once considering how in the world she was to get out again."¹

Much like when Alice jumped down the rabbit hole, navigating a path through multiple finance agreements that contain complex legal provisions at a time of financial distress can lead borrowers to wonder how they will ever find a way out.

Sources of complication

In most cases, confusion for sovereign borrowers arises because financing agreements typically are drafted with provisions that seek to ensure creditors will have a seat at the table when signs of financial distress appear on the horizon, if some form of rescheduling or restructuring may be contemplated. This is true in both official sector and private sector documents, with the only distinction drawn between domestic debt (usually local market debt issued in local currencies) and external debt (issued in foreign currencies). As a result, the terms of official sector debt often contain clauses that could trigger breaches in private sector debt documents, and vice versa.

In addition, there is often a lack of consistency across agreements, including terminology related to enforcement rights. Given the way that financial agreements are designed to interlink in the face of financial distress, borrowers must have a thorough understanding of their financing agreements before deciding to commence any form of debt negotiations—even where it is actively encouraged by a creditor or class of creditors. This is necessary to manage the process in an orderly fashion without triggering unintended consequences in other financing arrangements, which can start a "domino effect" of potential defaults across multiple agreements.

For example, one provision in the terms of a financing agreement for one sovereign nation makes it a default if the relevant country "discontinues its payments to creditors or commences negotiations with one or more of the [country's] creditors on a moratorium, waiver of debts outstanding, deferment of payments or discontinuation of debt service." This broad default provision does not relate specifically to financial indebtedness or to external debt, and so (in theory) it would capture non-payment to commercial creditors. It would also be triggered if the relevant country starts to negotiate with one creditor in relation to the deferment of payments or discontinuation of debt service. Therefore, even if the lender never intended either of these consequences at the time it made the loan, the country could easily find itself in default under this agreement.

Then there is the domino effect that defaults produce in other agreements. This particular provision is drafted as a default (i.e., a default will occur if the country takes any such action). In a different financing agreement for the same country, a default provision states that "an event of default occurs [under this agreement] if an event which constitutes a default occurs under any other agreement involving the borrowing of money with a bank or financial institution." So unless it is managed in an orderly fashion, breaches of agreements can quickly spread across other agreements making it difficult for the country, like Alice, to consider how in the world to resolve the problem.

Finally, once a financing arrangement has been signed—whether governed by English, New York, French, Chinese or "international" law—unless the agreement terms contemplate changes as part of any debt negotiations (which is unlikely), any changes to the agreement terms evidencing the debt must be agreed between the parties and documented as an amendment to the original documents. This legal principle protects parties to agreements from seeing the terms unilaterally changed or having subsequent laws amend previously agreed commercial terms. No law of any country regularly used for financing agreements will allow terms to be retroactively applied to the document, thereby amending them without the agreement of the parties. So to avoid being in breach of the contractual terms of the agreement evidencing the debt, the sovereign borrower must enter into amendment agreements related to the affected debt.

It is in this context that sovereign borrowers should consider the various relief packages being offered.

If there is a fiscal or other imperative for a country to seek debt relief, it should do so on an informed basis to avoid a potentially disorderly process. The debt management office charged with managing that country's debt should fully understand the impact that any creditor engagement will have on that nation's financing arrangements. It also should actively manage any of its agreements that contain broad creditor-engagement provisions in advance, to avoid triggering a breach under those agreements and potentially then triggering defaults under other agreements.

View full image: Change in government debt (as percent of GDP) from 2016 to 2020 (PDF)

The DSSI

The DSSI is available to countries that are eligible to receive assistance from the World Bank's International Development Association and to all nations defined as "least developed countries" by the United Nations.

Many countries have been hesitant to engage in discussions thus far, in part due to concerns about triggering debt defaults and rating actions that could impair access to future financing. Although the DSSI itself applies only to a country's official bilateral debt, deferring or suspending debt service payments to its bilateral creditors could be enough to trigger acceleration or default provisions under the country's loan agreements or bond terms. As the broad default example above shows, a formal request to suspend payments as required under the DSSI could easily trigger this type of default, since it is clearly the commencement of a negotiated process to defer payment of debt service.

Countries may not have such terms in their financing portfolios, in which case it would require a consideration of the specific terms that do apply to ensure that the formal request does not trigger a default. A well-advised country normally can conduct its creditor engagement and communications in such a way as to ensure that if at all possible, "obvious" defaults are not triggered. For example, a country could make sure not to "declare" a moratorium on its external debt, as this is a common Eurobond default provision across many sovereigns.

The Institute of International Finance (IIF) estimates that debt service payments owed by DSSI-eligible countries from the start of May through the end of 2020 amount to approximately US$11 billion for official bilateral lenders, US$7 billion for multilateral lenders and US$13 billion for private creditors. Clearly, any meaningful support for these countries must therefore encompass multilateral and private lenders in addition to the official sector.

While the DSSI encouraged private creditors to participate on comparable terms, participation is voluntary. The G20 nations acknowledge that negotiating private-sector participation in particular will likely be a lengthy process, due to the DSSI's abstract terms and the unique position of each debtor country.

In addition, countries that wish to maintain continued market access should be aware that part of the terms of the DSSI prevent raising further private debt unless otherwise agreed.

Further, this may impact the ratings of both lenders that provide relief and countries that benefit from it. Rating agencies will consider any deferment or change in payment terms for a country that results in a diminished financial obligation to be a default. And lenders' ratings may be impacted if they defer a large number of facilities, since at least one rating agency has indicated that delays of principal or interest payments on a sovereign loan lasting more than six months would lead it to classify the lender's full exposure to this sovereign as impaired, which could affect the lender's credit profile. Multilateral lenders would also need the support of their member countries. The President of the World Bank Group stated recently that multilateral lenders would require full compensation from shareholder contributions if they were to participate.

PRIVATE CREDITOR PARTICIPATION

Voluntary, case-by-case participation

The IIF—a trade association representing the private creditor community and comprising nearly 450 leading financial institutions from more than 70 countries—wrote a letter to the IMF and World Bank in May, offering broad qualifications for any private sector participation in the DSSI. It highlighted the need for a case-by-case approach, stating that debt service suspension would be based on the underlying legal documentation and that individual creditors would each need to determine whether their fiduciary duties allow them to participate in the initiative and on what terms. It also made clear that participation would need to be voluntary, without prejudicing any enforceability rights such creditors may have.

However, while acting individually and voluntarily, creditors will also expect each country to seek broad participation, with such initiatives supported widely across the private investor community to support fair burden sharing. This could put a lot of pressure on a sovereign country, and may require extensive rounds of negotiation and outreach to achieve a sufficient threshold level of participation, such that individual creditors are willing to participate. Again, as highlighted above, this would also require sovereign governments to navigate the terms of their financing agreements to ensure that any negotiations do not trigger defaults under financing agreements, further complicating the country's ability to manage the process in an orderly fashion.

The issues considered above related to ratings would be equally relevant to private sector negotiations. In addition, depending on how processes are managed, sovereigns could find themselves dealing with different groups of creditors, which may have different interests that need to be managed.

Mandatory, blanket participation

Many commentators have highlighted the shortcomings with voluntary private creditor participation and called for an automatic, blanket standstill on debt repayments, arguing that without mandatory participation, any debt relief afforded to eligible countries would simply be used to service private sector debt to those creditors that did not participate, rather than to finance health-related expenditures to combat the COVID-19 pandemic.

The United Nations Conference on Trade and Development (UNCTAD) has proposed a comprehensive temporary standstill on debt repayments, including all external creditors and with possible annual renewals based on debt sustainability assessments. However, implementing a collective and automatic participation can also raise problems. Any unilateral change in a debt repayment schedule would result in a default under those financing agreements and likely a cross-default in others, as well as a decline in the credit rating of the relevant country, the combined effect of which would likely prevent further market access until the situation had been resolved. Moody's has indicated that any suspension or delay of payments to private creditors, unless permitted under the contractual terms, would likely cause a default under its definition. Moody's has already placed ratings under review for several African countries, including Ethiopia, Côte d'Ivoire and Senegal.

Since the legal regimes under which most of the debt has been incurred do not contemplate such a standstill process, any initiative would also require an overarching legal mechanism to shield sovereigns from defaults, litigation or enforcement actions. UNCTAD has called for an immediate stay on all creditor enforcement actions and for jurisdictions that govern most emerging market sovereign bond documentation to deter lawsuits against debtor countries. Yet modifying the relevant laws in the United Kingdom and the United States—which govern the majority of sovereign bonds—would be lengthy, complex and perhaps ill-suited to the urgency of the current situation—even if it were politically acceptable within those countries.

Debt exchange

The African Union and the UN Economic Commission for Africa announced a proposal for African countries to exchange their commercial debt for new concessional paper, and they are designing a special-purpose vehicle for the swap, guaranteed by a triple-A-rated multilateral bank or a central bank. The initiative would convert the current debt into securities with a longer maturity, benefiting from a five-year grace period and lower coupons.

The proposal is in the early stages. But for any exchange to be effective, it would need to sweep up dissenting or hold-out votes, potentially increasing the risk of litigation, particularly if the economic terms were materially worse for holders changing from "B" rated debt with a certain yield to "AAA" debt, as well as navigate any tax consequences for such holders. This would also only deal with debt in the form of bonds. So its limited focus would still leave countries needing a solution under their other financing agreements or government guarantees, which can often contain more restrictive provisions and wider defaults, with earlier trigger points, than public financings.

Central credit facility

Another proposal by a group of sovereign debt experts is to create a central credit facility (CCF) with a multilateral development bank, such as the World Bank. Each country requesting relief would deposit into the CCF all interest payments on commercial and bilateral debt falling due during the prescribed standstill period, which would be reinvested and redeployed to finance a predetermined and monitored set of emergency expenditures arising out of the COVID-19 crisis. Creditors entitled to those interest payments would receive in exchange an identical instrument representing an interest in the country's CCF. This instrument would correspond to the amount of the creditors' reinvested interest payments and would enjoy de facto seniority in any future liability management transaction of the debtor country. Receiving this instrument would constitute a full discharge and release of the debtor's obligation in respect of the interest payment. A similar mechanism could be implemented for deferral of principal payments.

More detail is needed to understand how this innovative proposal would work in practice, and it remains unclear whether governments will adopt the policy. Participation of private creditors would still ultimately be on a voluntary basis, and such participation would require the consent of each creditor to amendments of the underlying legal agreements through a formal consent solicitation process that carries the destabilizing risk of holdout creditors.

CONCLUSION

Many questions still remain regarding the implementation of the DSSI, in particular around the extent of collaboration from the private sector and what the potential credit rating, market access or other longer-term consequences might be for countries that choose to participate (or not) in a sovereign debt relief initiative.

In the absence of an overarching legal mechanism to shield sovereigns from defaults, litigation and enforcement actions, it will be challenging to come to a collective agreement, whether on a voluntary or mandatory basis.

Instead, each country will likely need to conduct a wholesale review of its financing commitments to identify potential triggers and negotiate individually with its creditors: a time-consuming and potentially costly exercise. Although a number of interesting and innovative proposals have suggested what form private sector participation might take, they do not yet solve the fundamental legal problem. Ultimately, the underlying finance agreements and bond documents are private commercial acts of each sovereign, and a failure to pay interest and/or principal amounts when due is a breach of the agreement, as it would be for any other debtor.

_{1 Alice's Adventures in Wonderland, by Lewis Carroll}

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