Redesigning the International Lender of Last ResortPatrick Bolton and David A. Skeel, J[,'

ABSTRACT

This paper is concerned with the issue of how to balance bailouts (or"lending into &rrears'~ with debt reductions (or "private senorinvolvement") in the resolution of sovereign debt crises. It provides areview of recent proposals for improving the sovereign debt restrucruringprocess. In adclicion to defending a sovereign bankruptcy proposal we havepm forward in recent work. this article proposes a major reorientation ofthe h\1Ps role in sovereign debt crises.

1. INTRODUCTION

Since the Mexican Debt Crisis of 1994--95, which gave rise to aoInternational i\ilonctary Fund ("IMP'') bailout of unprecedented size. there hasbeen a raging debate on how the IMF should handle sovereign debt crises.Despite the successful resolution of the crisis and Me,uco's quick repayment ofall its emergency debt, the sheer size of the intervention has raised worries thatbailouts could cause significant sovereign debt market distortions. Theseconcerns, in turn, have led to a reconsideration of the prevailing wisdom that theliVlF can and shouJd act as the de facco international lender of last resortC'ILOLR'') by arranging bailouts in response to major sove.reign debt crises. Asis now widely recognized, the problem with a purely bailout-based policy is thatit requires ever larger funds to be credible and successful. It also invitesundesirable policies by debtor countries. The prospect of a bailout encouragessovereign debtors to borrow more than they should, and it temptS them toreSort to highly risb.-y fIxed exchange rate policies as a quick fix towards

John 1-1. ScuUy '66 Professor of Finance and .Economics, Pcincc(on University; S. Samud Arsh(Professor of Corporate Law, University of Pennsylvania. We are grateful to Bill Bratton, LeeBuchheit, Douglas Diamond, Mitu Gulati, Jim Feinennan, Dan Tarullo, Kathy Zeile( and (0

participants at a workshop at GeorgeLOwn University Law Center and a( the IPD-UN So\'ereignDebt lnirauve meetings at Columbia Uni\'ersity for helpful comments on earlier drafts-

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macroeconOITllc discipline. 1 Of course, the worst debtor misconduct can becontrolled to some extent by imposing conditions on the debtor country beforegranting a rescue program, but more often than not, the IMF finds itself in aweak bargaining position at the onset of a debt crisis. How credible is the L\1Fthreat to withhold a financial aid package when a potentially contagious debtcrisis is about to erupt? And once the bailout has been granted, why should thedebtOr country abide by the conditions it agreed to?

Because of the potentially enormous financial commitment a pure ILOLRpolicy requires, and because of the moral ha~ard it may inducc in sovereign debtmarkets, it is now widely understood that bailouts need to be supplemented byat least a partial <CbailinH of the private sector. According co this view, the IMF'sinvolvement in a debt crisis should be conditioncd on debt reduction orrescheduling by private scctor lenders. Private creditOrs should be required, thatis, to share at least some of the cOSts of resolving a crisis. Despite dlls emergingconsensus on the importance of private sector involvement, however, there isstill considerable disagreement on the appropriate balancing bctween bailout andbailin, and on the best process for crisis resolution and debt restructuring.

The most ambitious overhaul of IMF policy contemplated so far involvesthe introduction of some form of bankruptcy institution for sovereigns andenvisions a single forum where the extent of debt reduction and the size of newemergency lending would be decided simultaneously. There was considerablediscussion and research of this strategy-which the IMF calls a Sovereign DebtRestructuring Mechanism ("SDRM'')-from late 2001, when rhe TMF fIrstannounced its support for a sovereign bankruptcy framework, up to the G-10meetings in April 2003, when rhe TMF's proposal was shelved. Despite all rhewriting and debates, many open questions were still unresolved at the time of theG-IO meetings, including the role of rhe IMF in an SORt\{ regime. No doubtthese questions would have received further attention if the SDR1VI proposal hadgone forward. But in the aftermath of the SDR.L\1 debate, no clear new role hasbeen marked out for the li\1F and no clear rules have emerged to direct thel.tVlF's balancing of bai1ins and bailouts in future debt crises.

As a result, the It\1F now finds itself at a crossroads. Should it be comentwith the status quo and accept that it will be less and less equipped to deal withmajor emerging market debt crises? Or, on the contrary, should its size be

The: IMF wrs its O\l<n share of responsibility in recommending such policies. For crincalassessments of IMF policy recommendations on macroeconomic st:2bilization and interventionduring the Asi2 crisis of 1997-98, see P:1.U1 B1ustein. Thl ChaJt(lling: blIitk tlx Crins that RtxJud theGlobal FilltmdiI/ SJIftJ11 and HIi",bkJ 1M IMF (PublicAffairs 2(01) and Joseph E. Stiglitz,CltJbah'za!ion and lis Duron/tnls, 89-132 (NonDn 2002). For a more sympathecic view, see NouriclRoubini and Brad Setser, BoHoNls or Bail-iflJ?: &pqndi"g to Fi"andal emu i" E",~i"g Eronol1fiu (lnstInti Eeon 2004).

178 Vol 6 No.1,

considerably expanded, possibly by granting a more powerful role to Japan,China and other East Asian countries that are sitting on massive idle foreignexchange reserves? Or. even more radically, should the IMP disclaim any role incrisis lending and confine itself to an advisory and forecasting function, as Chariand Kehoe, Rogoff, and others have urged"

In this paper, we argue that by establishing an adequate bankruptcyprocedure for sovereigns, the international community could both fully addressthe problem of sovereign debt restructuring and redefine an ambitious crisisresolution role for the IMF. Far from stepping away frOID a crisis lending role,we argue that the li\1F could, without increasing the size of its funding, enhanceits lLOLR role within the framework of a sovereign bankruptcy procedure. Howdo we square this circle?

Corporate bankruptcy provides a useful analogy for describing the new rolewe envision for the TMF. \X'hen a nonfinancial corporation ends up in financialdistress. it does not, as a rule. seek a bailout from the government. Instead it ftlesfor bankruptcy, thus receiving temporary relief from its creditors. This relieffrom creditors-or Ustay"-is the characteristic of corporate bankruptcy thathas been emphasized most in the sovereign context. But, in addition to a stay ondebt collection, and more significant for our purposes. the disrressed firm canalso ask the court to approve new priority lending-usually in connection withso-called "first day orders" that authorize the company to continue paying itsemployees and thus preserve its going concern value.} \'(Ihen the bankruprcycourt grants new priority lending. it is not extending its own funds, as the IMF

In his powerful analysis of the history of World Bank and IMF lending over the paSt sixty years.Rogoff argues:

[MJy long-held view is that the Fund would serve better if it made no loans. Ina nutshell. the Fund's current resources of S150 billion seem like enough [Q

cause moml-hazard problems (that is, to induce e.."occessive borrowing) withOutbeing enough to deal with a really deep global financial crisis. The Fund is justtOO politicised to bt: a con.sistently effective knder of last resort, and if itsfif12ncial structure is nm changed. there are always going to ~ A~tinas ...No. the right future for the Fund. as for the IBRD. is to phase itself out of thelending business. The Fund can still make itself very useful in cOootdinatingthe global flnancial system. in offering technical advice, and perhaps even inissuing debt ratings 10 countries that requCSt iL If the global community canwork its way towatds an improved bankruptcy procedure for sovereignborrowers, this path will be fat easier. 1 would recommend it regardless.

Kenneth Rogoff, TIN Sis/err at 60, Economist 63, 65 Qull' 24, 2004). Sec also V.V. Chari andPatrick J. Kehoe, AJk:"llg tm RighI QIdSliOlfJ ahoJit tIN r"fF. Federal Reserve Bank of ~finneapolis

Annual Report Issue (1998) (arguing dut there is no need for the lJ\IF to sen·e as lLOLR giventhat me cencra.l banks of the G·7 can already intervene directly in the event of a crisis).

First day orders ate describ<:d in Marvin Krasny and Kevin J. Carey, Editors RIp!! to an AnonymoJlJutter, W~ is Ddaa'OT't Ibt Vtnut If Choi~ ftr Philatklphio·Basd Compmtiu? Legal lntelligcncer 9(March 22, 1996); Marcus Cole, "Dt!aa'OT't is Nol Q Sfok": An IPt WitluJs1l1g}JlriJdiftiqu/ UmfJfhbml

i" Banl:ntplfJ?, S5 Vand L Rev 1845. 1856 n 58. 1864--6S (2002).

Redesigning Iht lnltmahonol und~rofLut&sori

2

Summtr 2005

'.

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Chicago JONrnal ofInlmranolfo/1...olII

does when it puts together a financing package for a distressed sovereign. All thecourt does is make way for new lending by the private sector-often the samelenders that have already lent to the distressed firm in the past-by granting thenew loans higher priority starns.

\Y/e suggest that, just as a bankruptcy court does for corporations, the IMFcould play the role of granting first-day orders to distressed sovereigns in thecontext of a sovereign bankruptcy procedure. Importantly, the IMP would notneed any new funding to exercise this authority. Thus, a major additional benefitof sovereign bankruptcy is that it could open the way for a new enhanced rolefor the IN[f. This new role would indeed strengthen the Th1F's hand. as it wouldenable the IMP to facilitate much larger emergency lending packages consistingnot just of IMP funding but private lending as well. In addition, it would notgive rise to the same concerns about moral hazard as does the current form ofintervention mat relies on publicly funded I1VIF bailouts. In particular. since thefund would no longer JUSt be extending its own funds, it would be subject to

greater market discipline. The private lenders mat me LVlF would invite to

provide the new capital could be expected to do so only if there were a plausiblefinancial rationale for extencling the loans. Moreover, the IMP could not extendpriority scatus too liberally without imperiling its very existence.

To achieve this resrrucruring of the ThW's role, the underlying sovereignbankruptcy framework would need to provide coherent and enforceable priorityrules.4 1n earlier work that did not envision this new role for the IMP, we arguedthat solidifying creditors' seniority rights may be the single most importantbenefit of establishing a sovereign bankruptcy regime.; In this Article. we takethe analysis a step further, to incorporate a reconceptualized role for the IMF-arole that would avoid the increasingly real risk that the L\J[f might otherwisebecome obsolete.

The remainder of our article proceeds as follows. In Part II, we discuss therecent policy proposals for improving the sovereign debt restructuring process.\Y/e also consider the extent to which the benefits of a Statutory procedure couldbe achieved through contractual alternatives, and briefly explore the implications

At a minimum this new role for the fMF is possible only if higher priority status can be granted toemergency lending. So Fou, the Il\{F has been able to implicidy enforce higher priority on irs ownand other Inte.rnational Financial Insunttion ("IFI'j loans. Howe..·er, this de facto priority is partlyan illusion as the IMF has generally agreed to roU over itS loans when the sovereign was uruble orun.....illing to pi)'. This higher prioriry SUNS has also recendy been rested by Argentina followingits defauh on sovereign bonds. Conceivably, the 1~'IF could alrcady play the new role wepropose-grancing higher priority to emergency loans from the privare sector-under the currentlegal environment. However, de facto, implicit enforcement of priority is likely [0 be moredifficult ro scale up and may need [0 be shored up by legal enforcement through the COUrts.

Patrick Balron and David A. Skeel, Jr., Insidt tht Bloll: &x: How Shod' Q Sovrreign Banl:rup4YFromtJl.YJrl: Bt StnldJmti?, 53 Emory LJ 763, 766--67 (2004).

'i<180 VoL 6 No. l'

does when it puts together a financing package for a clistressed sovereign. All thecourt does is make way for new lending by the private sector---often the samelenders that have already lent to the distressed fIrm in the past-by granting thenew loans higher priority starns.

W/e suggest that, just as a bankruptcy court does for corporations, the IMFcould play the role of granting first-day orders to distressed sovereigns in thecontext of a sovereign bankruptcy procedure. Importantly, the lMF would notneed any new funding to exercise this authority. Thus, a major additional benefitof sovereign bankruptcy is that it could open the way for a new enhanced rolefor the IMF. This new role would indeed strengthen the IMF's hand, as it wouldenable the IMF to facilitate much larger emergency lending packages consistingnot JUSt of I1\ofF funding but private lending as well. In addition, it would notgive rise to the same concerns about moral hazard as does the current fonn ofintervention that relies on publicly funded IMF bailouts. In particular, since thefund would no longer just be extending its own funds, it would be subject togreater market discipline. The private lenders that the IMF would invite toprovide the new capital could be expected to do so only if there were a plausiblefinancial rationaJe for extending the loans. Moreover, the IMF could not extendpriority stams too liberally without imperiling its very existence.

To achieve this restructuring of the IMF's role, the underlying sovereignbankruptcy framework would need to provide coherent and enforceable priorityrules.~ In earlier work that did not envision this new role for the IMF, we arguedthat solidifying creditors' seniority rights may be the single most importantbenefit of establishing a sovereign bankruptcy regime.s In this Article, we takethe analysis a step further, to incorporate a reconceprualized role fot the .l.1\1F-arole that would avoid the increasingly real risk that the IMF might otherwisebecome obsolete.

The remainder of our article proceeds as follows. In Part 11, we discuss therecent policy proposals for improving the sovereign debt restructuring process.We also consider the extent to which the benefits of a statutory procedure couldbe achieved through contractual alternatives, and briefly explore the implications

Vol 6 No.1180

At a minimum this new role for the [1I.{F is possible only if higher priocity Status can be gnnted toemergency lending. So far, the IMF has been able (0 implicitly enforce higher priority on itS ownand other Inrernational Financi2.1 Institution ('lFI') loans. However, this de facm priority is partlyan illusion as the IMF has ~nerally ~eed to roll over its loans \I.'hen the sovereign was unable orunwilling to pay. This higher priority stams has also recently been tested by Argentina followingits default on sovereign bonds. Conceivably, the IMF could already play the new role wepropose--granting higher priority to emergency loans from the private sector-under the current1cga.1 environment. However. de facm. implicit enforcement of priority is likdy to be moredifficult to sale up and may need to be shored up by Itgal enforcement through the courtS.

Patrick Bolton and David A. Skcd, Jr., Jnsid~ the Blotk Box: How ShDNId a SOJl!'n'Ji" BankfllptlJFromtlWrk Be Sln/ttNrr"?, 53 Emory L J 763,766-67 (2004).

,

Rtdeng!ling the International under ofLmt Rnorl Bolton & Skeel

of the recent debt crisis in Argentina. Part III maps out the new role for the IMFand assesses how IlvIF actions in debt crises may need to be circumscribed.

IT. INTERVENTION IN DEBT CRISES AND POLlCY DEBATES

A wide range of reforms have been proposed as a partial or completesolution to the concerns described in the introduction. Such propositions haveincluded greater use of collective action clauses ("CACs'j in bonds, a structuredmediation or arbitration process for addressing sovereign debt crises, andvarious fOnTIS of sovereign bankruptcy. This section first briefly discusses CACsand some problems with their use, and then focuses at greater length on theIMF's sovereign bankruptcy proposal, and on our own proposed framework-amore e.xpansive alternative to the .I1vIF proposal.6

Sovereign bonds governed by UK law have long included CACs specifyingvoting rules that permit a predetermined majority of bondholders ro adjustpayment or interest terms in the event of a debt crisis. In contrast, bondsgoverned by New York law have traditionally given each bondholder veto powerto decide whether or not to agree to a restructuring. In the 1990s, an increasingnumber of commentators concluded that the New York "unanimity" approachmade restrucruring tOO difficult. To facilitate coordination among thesovereign's bondholders, and to counteract the threat of holdouts, they argued,sovereign debtors should include CACs in all of their bonds.7

At its April 2003 meetings, the G-lO, led by the US Tteasury Depattment,endorsed a poJjcy that stricdy limits private sector involvement ro only avoluntary inclusion of CACs in sovereign bond issues. Partly to stave off moredrastic intervention in sovereign debt contracts and pardy to placate the USTreasury. issuers have since introduced CACs into their new sovereign bondissues. In mid-2003. Nfexico very publicly issued New York-registered bondsthat permitted changes to the payment terms of bond with the consent of 75percent of the holders, and several other sovereigns, including Uruguay andBrazil, followed suit.s

6

7

•

Id.

FOT an (:arly, influ(:ntial emphasis on CACs, S(:e Barry Elchengreen and Richan:l. POrtes, ensis?(What Crisis? Or-duIJ WorkOllts for Sovmigl/ D~btofJ 49 (Centre for Econ Poly Rsrch 1995). Morerttently, Mitu Gulati has wriuen extensi\'ely about the use 2nd promise of CACs. See, forexample. Lc:c: e. Buchheit and G. Miru Gulati, SOPUrfgn &ntb und tlx Colkrtiw Wil4 51 Emory L J1317 (2002). For a nuanced view of th(: choice ~twecn CACs and the unanimity approach, stt

William W. Branon and G. l\liru Gulati, Sot-rmgn D~bt Rtfonn and tIM Btlt InttTlst oj Cmliton. 57Vand L Rev 1 (2004).

Since the end of 2003, nearly every new issuance of sovereign bonds has featured a CAe.lmerestingl}'. the latest Uruguayan bond issues also include an aggregation muse that pennitS acombined vote of all the classes of bonds that include the clause. Tne clause is designed [0

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A. THE IMF's SOVEREIGN DEBTRESTRUCTURI, G l'vIECHA, ISM

Despite these encouraging developments, however, there are still severalreasons to suspect that CAC enthusiasts have oversold the virtUes of the newclauses. First, CACs are more effective for restructuring one or a small numberof classes of bonds, than for sovereign debtors with a more complicated capitalstrucrure.9 Second, although CACs help counteract collective action and holdoutproblems, they do nothing ro remedy any seniority and debt dilution problemsas we explain below. CACs also do not address concerns such as the need for astandstill while the sovereign debtor is renegotiating its obligations. lO Because ofthese shortcomings, we believe that a more interventionist policy, such as thestatutory approach advocated by the IMP, is called for.

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obviate the need for separate votes for each class of bonds by creating the possibility of a single,interclass vote on the tenns of a restructuring. These developments are recounted and analyzed inStephen J. Choi and G. J\{itu Gulati, Inn()~'iltUJn in Boilerplate GmlnHtJ: All Empirifal Examination ofSo~'ffl1Wt Bonds, S3 Emory L J 929 (2004) and Stephen Choi and G. ~1itu GuJati, The Ero/Mtion of&ikplate ConJradJ: Emknn..fro", the Sovmigr1 Debt Mtritt (2004) (unpublished manuscript) (on filewith the authors).

'llUs point IS discussed in more detail in David A. Skeel, Jr., Can Majority Voting Provisions Do itAU?, S2 Emory L J 417 (2003).

Bolton and Skeel, 53 Emory L J at 773-76 (discussing this and additional shoncomings) (cited innote 5).

i\luch of the description and analysis in this section is drawn from Bolton and Skeel, S3 Emory LJ at 776-80 (cited in note 5). The IMPs first detailed proposal was Ill-·fF, The Design of the 5ot:JmignDebt IVJJruftllnng M«bdlrim1--FNTtbtr ConJitkmJiDnJ (Nov 27, 20(2), a,,·ai.b.ble online at<http://www.imf.orglextemal/np/pdr/sdrm/2002/112702.pdf> (,,;sited ~far 15, 2005). lbisproposal \\'1lS subsequently adjusted. IMF, Propoud FeaJuru ofa 5mwrign Debt RLitniftlln'ng M«banimJ(Feb 12, 2oo3), available online at <http://www.imf.org/extcrnal/np/pdr/sdnn/2003/021203.pdf> (visited Mar 20, 2005).

""

The IMP's sovereign bankruptcy initiative was first announced in aNovember 2001 speech by Anne Krueger. The IMF staff subsequently produceda series of detailed draft proposals outlining an SDR.LVl in 2002 and early 2003.Because the INIF's proposal has been the lightning rod for recent debate oversovereign bankruptcy, we will explore it in some detail before considering our

d I. II

own propose a ternatlve.The guiding concern of the Th1F's proposal is to resolve collective action

problems among dispersed creditors in debt restructuring negotiations, whilepreserving creditor contractual rights to the greatest extent possible. Viewedfrom this perspective, the key element in the Il\1F's proposed mechanism is amajority vote among creditors on a restructuring plan that would bind adissenting minority. With the aim of preserving creditor rights, the livIF's plan

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RLdtJigning the IntmtaJionol Lendu ofLut IWorl 801m. & Sked

stopS short of envisaging a stay on litigation and individual debt collectionefforrs or a srandstill on debr paymenrs. The relative clifficulry of collectingsovereign assets, as opposed to corporate assets, is the main justification givenfor not introducing an automatic stay into an SDRM.

The main limitation on plaintiffs' gains envisioned by the IMP mirrors alegal rule in international insolvency law known as the "Hotchpot rule." Thisrule requires that any payment or asset collected by a plaintiff through litigationmust be offset against the plaintiffs claim undcr the restructuring agreement.That is, any new claim the plaintiff would be entitled to under the restrucruringagreement would bc reduced by an amount equal to what the creclitor obtainedrhrough legal action. Should rhe plaintiff obrain more rhan whar rherestructuring agreement specifies, the "Hotchpot rule" could be supplementedwith a dow·back provision-but the {N[F's proposed plan exc.ludes such aprovision on the grounds that it would be impractical.

The "Hotchpot rule" clearly reduces incentives for pr.ivate litigation, but itdoes not eliminate them. Also, it does not directly address the concern thatprivate litigation may be undenaken mainly as a negotiation or delaying taeric­for example by undermining the sovereign's ability to trade. The IMPs proposedplan recognizes this issue and proposes that a judge could have authority to stayspecific legal actions on request of the debtor and subject to approval ofcreditors.

The voting provision and the "Hotchpot rule" are the centerpieces of theTh1Fs proposed plan. The plan also cOntains many more technical provisionsdealing with notification of creditors, registration, and verification of claims. Asin corporare bankruprcy rhese can be lengrhy and difficulr processes. Animportant additional complication is that the ultimate ownership of a sovereignbond is hard to trace. The court must be able to pierce through the veil ofbeneficial ownership to be able to ascertain whether the votes on a particularbond are controlled by the sovereign. Should that be the case, these votes oughtto be ineligible for obvious conflict of interest reasons. 12 A related difficulty isthat for widely dispersed debt structures many claims may not be registered intime. Given the large number of claims that will not qualify, a requirement that asupermajority of '(registered" claims approve the plan may function more like asimple majority requirement in practice-thus resulting in weaker prorection of

" The problem of sovereign control of key claims, and mrough these claims, of a vote by creditors,figured prominently in a sovaeign debt dispute involving Brazil in the 19905. Through Banco doBrasil, which had participated in a syndicated loan agreemeot, Brazil managed to thwan an dfonby other debtholders to accelerate the amounts duc: under the loan. ClBe Banl: and Trust Compo'!]/I Banco Ctntral do BroJil, 886 F Supp 1105, 1118 (SDNY 1995) (refusing to intervene to imposeimplied obligations of good faith and fair dealing). For discussion and criticism, see Branon andGuhllj, 57 Vand L Rev at 7S-77 (cited in note 7).

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ChuagoJOllmal oflnlmutlional Law

creditors. These difficulties underscore the need for a court-supervisedrestrucruring procedure as well as the important benefits that might be availableif an international clearinghouse were established.

Because the principal concern of the IMF's proposed plan is resolving ofcoUective action problems among sovereign bondholders, the mechanism isunderinclusive and incomplete as to the two other major facets of a restructuringprocedure: the provision of interim financing and enforcement of absolutepriority. The plan's only means of enforcing absolute priority is through theexclusion of several classes of debt from the SDR..i\1. Thus, the plan proposes toexclude privileged claims, obligations to international organizations such as theIMF ("multilaterals'), and debt owed to other nations (the "Paris Club'} TheIMF proposal also gives the sovereign debtor discretion to exclude other debtclaims-such as trade credit, claims on the central bank, etc.-from the SDRM.An obvious clifficulty with this approach is that it gives the debtor considerablepower to undermine a given priority structure and to cut side deals withparticular creclitor classes in exchange for an exclusion of the claims from theformal SDRJ.\1 proceedings.

The plan recognizes some of these clifficulties and offers, as an alternative,to include Paris Club debt in the SDRM under a separate class. The plan alsoallows for other forms of classification and gives the debtor cliscretion to classifysubject to the general requirement that classification does not result inunjustified cliscrimination among creclitor groups. 13 While classification bringsabout greater flexibility it is important to understand that it does not in any wayguarantee enforcement of absolute priority. To the contrary, as currentlystrucrured the nvrF's plan may well facilitate deviations from absolute priority bygiving a veto power, unconstrained by a cramdown or best interest rule, to ajunior creditor class.

Just as the I1\fF's plan does not systematically address the issue ofenforcing absolute priority it also only gives lip service to the issue of debtor-m­possession ("DIP'') financing. With the objective once again of preservingcreclimr contracrual rights as much as possible, the Th'IPs proposed plan onlyallows for "priority financing" if it is approved by "75 percent of outstandingprincipal of registered claims." 14 The main purpose of DIP financing is toaddress an immediate cash crisis and allow the debtor to function whilerestructuring negotiations are ongoing. Clearly, a creclitor vote would beextremely clifficult to organize in a timely fashion, making it virtually impossibleto organize any such fmancing.

IMF, The Design 0/ tlN Sovmign Debt RLJlnKhtring Merhanis_FMTtbtr Co1tsUkratu;ns :1.[ 2S (cited innme 11).

Id :It 23.

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RLdtsigning the lntemah'onal Lend" ofLuI Rna" Bolton & Skul

The last key component of the IMF's plan is its proposal to set up anindependent Sovereign Debt Dispute Resolution Forum rSDDRF") to overseethe sovereign bankruptcy process. IS The selection of SOORF judges would bedelegated to a selection panel designated by the IMF's Managing Director andcharged with the task of creating a shortlist of candidate judges that might beimpaneled when a debt crisis arises. The final shortlist would be subject to

approval of the IMF's governing board. The president of the SDDRF would becharged with selection of the final group of four judges to be impaneled in theevent of a crisis, While the plan goes to considerable lengths to guarantee theindependence of the SODRF it is still wonh noting that this procedure is not afoolproof method to guarantee the full independence of the court.

Overall, the Th1F plan is an extremely important development in ourthinking about how best to address sovereign debt crises. As this brief overviewmakes clear, however, it also has serious limitations. Most importantly, the TMFplan focuses extensively on the ex post issue of solving creditors' collectiveaction problems, but it pays much less attention to the equally important issue ofthe ex ante effects of an SORM-in particular, the need to honor creditors'priorities in order to facilitate sovereign credit markets. In addition. the IMF'sinterim ftnancing proposal is cumbersome and does not fully address thegrowing concerns about the nature of the IMF's funding and oversight role.Finally. the creation of an SOORF within the l1\1l.F itself raises independence andconflict of interest concerns.

B. ENFORCING SENJORITY

Although the I1vfF plan focuses on collective action problems. an equallyimportant problem is debt dilution and the lack of enforcement of seniority insovereign debt. 10 the absence of enforceable priorities. when a debtor countryapproaches financial distress any new debt it issues is partly at the expense ofexisting creditors who face a greater risk of default and wiJI have to accept agreater «haircut" (or debt reduction) in the event of default. since the totalresources the debtor can muster towards repayment of its stock of debt will haveto be divided pro rata among all its creditors, old and new. In earlier work, wehave highlighted how the lack of enforcement of an absolute priority ruleencourages overborrowing by the sovereign as it approaches financial distressand also raises its overall cost of borrowing.16

l'

16

Id at 227-73.

Bolton and Skeel, 53 Emory LJ at 771-72 (cited in notc 5). For a more extensive analysis, seePatrick Bolton and Olivier Jeanne, StfJI(1Nring mlfl &lfr'Urluring SOlltrtign Debt: Tht Role of Stniorily.available online at <http;!/gsbwww,uchicago.edu/research/workshops/finance/Bolton-JeanncOctober04.pdf> (visited Feb 9, 2005) (providing a formal analysis of optim.a.l debt

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Eager to avoid a default on its Brady bonds, the Peruvian Government decidedto settle following the court'S decision by paying Elliott in fulL20

Underlying the Brussels coun's decision was a seemingly straightforwardinterpretation of the pan'ptUsu clause. The clause states that «[t]he obligations ofthe Guarantor hereunder [the Peruvian Gove,rnment] do rank and will rank atleast paripassu in priority of payment with all other External Indebtedness of theGuarantor, and interest thereon."2\ The court interpreted this language asmeaning that when the debtor is unable to repay all its debts in full, all claims ofequal ranking under the pan'passu clause should get a pro rata share of the tOtalamount the debtor pays out. Most importantly, the court deemed that the debtorcould not make payments to some creditors (the creditors who agreed to therestructuring) and default on others (the creditors who held out and retainedtheir original bonds). It was on the basis of this interprctation that the coungranted Elliott Associates a restraining order against Euroclear, the entity to

which Peru had wired funds to pay consenting bondholders the scaled downamounts they had agreed to accept.22

The court's interpretation provoked a torrent of criticism. 23 Mostcommentators favor an alternative reading of the pari passu clause: that it isdesigned to prevent the borrower from issuing new debt that is senior to existingdebt. \Vhich interpretation the couns will adopt in the future is still uncertain,although in light of the outpouring of academic writing and briefs following theBrussels Opinion, the narrower interpretation favored by most legal scholarsseems likely to prevail.

T...ost in the hand-wringing over the Brussels Court of Appeals' novelinterpretation of the boilerplate pariptUsu clause is the possibility that the court'sremedy could open up a new strategy for enforcement of sovereign debtpayments-with far-reaching consequences not conceived of before. Crucial to

this possibility is the fact that the court granted a restraining order againstEUROCLEAR, rather than limiting irself ro a judgment against Peru.

To appreciatc the implications, start with Gulati and KJee's ominouswarning that:

"22

2J

G. Mitu GuJati and Kenneth N. Klee, Sovtreil,1t Piraq, 56 Bus Law 635, 635---36 (2001).

Id at 636. Stt also Elliott Anoa, LP v Boll(() tk fa j -ado". 2lXXJ US Dist LEXIS 14169 (SDNY Sept29, 2000) and Elliott Ama, LP 1I Rrpublic ojPtrJI, 2000 US Dist LEXlS 368 (SDNY Jan 18, 2000).

In effect, Elliott claimed that it was entitled both to claim its share of the payments being made toconsenting bondholders, and (unlike the consenters) to continue to insist on payment of the fullface amount of its bonds. See Gulari and Klee, 56 Bus Law at 636-37 (cited in nme 20).

For critiques of the Elliott ruling, see, for example, id at 635; \X'illiam W. Bratwn, Pari PtUJU tmd aDil/rumi SOvtrtil1"J Ratianal ChoiaJ, 53 Emory LJ 823 (2004); Lee C. Buchheit and Jeremiah S.Pam, Tht Pari PaJIU ClouJe in SQvtreil.1I Debt Inllrumentl, 53 Emory LJ 869 (2004).

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Under the old IMF bailout-based policy the enforcement of an absolutepriority rule was not a burning issue, since typically private creditors couldexpect repayment in full. But the shift in IMF policy towards private sectorinvolvement following the Russian debt crisis of 1998 has brought to light theissue of priority in repayment and introduced new uncertainty in sovereign debtmarkets by upsetting market expectations concerning seniority. Two subsequentevents roiled the waters still further: (1) the debt restructuring of Pakistan in1999-2000; and (2) the decision by the Court of Appeals of Brussels in 2000 togrant Elliott Associates, a vulture fund that had invested in Peruvian debt, arestraining order against Eurodear-preventing it from accepting transfers fromthe Peruvian government towards paying other creditors before Elliott's debtclaims on Peru had been honored.17

The first event, Pakistan's debt restructuring agreement of 2000, requiredfor the first time that Eu.robond holders be included in the restructuringagreement, thus shattering the market's perception that these debts had higherpriority StatuS. 18 The second event, Elliott Assoaales v Pent, alened the market tothe potentially far-reaching possibilities that the traditional interpretation of thestandard pan° passu clause in sovereign bond issues might no longer be valid,19and that private litigants could threaten to disrupt the transfer of funds fromsovereigns to creditors by obtaining restraining orders in court.

The new uncertainty as to which types of sovereign debt will be subject [Q

restructuring, and as to the meaning of the ubiquitous pari passu clause, haspropelled the issue of priority and debt seniority to the forefront of discussionsabout sovereign finance. Before examining how debt seniority can best beenforced, we begin by describing the Elliott decision and the legaJ debatesurrounding it in more detail.

El.lion Associates, playing an aggressive holdout strategy, refused to goalong with Peru's proposed Brady Plan debt restructuring of 1995. Instead, itattempted to obtain repayment on its debt by initiating a series of lawsuits andevennlaUy prevailed in the Court of Appeals of Brussels in September 2000.

Slructure in the absence of any legal enforcement of seniority). The authors show that creditorsattempt to achieve higher priority de facto by making their debl difficult to restructureo QveraU,lhis results in an excessively high COSt of financi'" distress. (d.

Elliott AJJ/l{J, LP II &1«0 de Ia Nation, 194 F3d 363, 366-67 (2d Cir 1999); Elliot AS50CS, LP,General Docket No 2OOO/QR/92 (Coun of Appeals of Brussels, 8th Chamber. Sept 26, 2000).

See Jeromin Zenelmeycr. The Gutfor an Explidr S/Niori!} SlnmN" ilf SO£'ffl"*" D(bt (Sept 29, 2003)(unpublished working paper draft, li\'lF Research Deparonem) (on file with authors) and AnnaGeJpem. BKilJing 0 &tter S(ohttg Cborl for Sowmgn &JtniltNringJ. 53 Emory L J 1115, 1128-30(2004).

The compecing interp~ucions of the pan0 ptum clause are described be.lowo See note 23 andaccompanying [ext.

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What the Brussels Opinion docs is to put a large hammer in the hands ofholdout creditors, thereby enabling them to cause even more disruption inrestructurings. Those inclined to be holdouts have a stronger position. andit encourages others to hold out. For the sovereigns and, we argue, for themajority of creditors, this is a nightmarish situation.24

The restraining order does indeed amount to a big stick for creditors.which plausibly should not be put in the hands of holdout cteditots. Interestingnew possibilities. however, can be imagined if one thinks of this stick aspotentially applying to the enforcement of debt payments and seniority moregenerally. If creditors' inability to seize assets and a sovereign's limited capacityto issue collateralized debt interfere with a sovereign's ability to borrow, then aneffective way of relaxing the sovereign's borrowing constraint may be to givecreditors the means to credibly threaten to shut out a defaulting sovereign frominternational financial markets by preventing it from paying off new creditors.

The greater enforcement powers made possible by Elliott-type injunctionshave inspired several commentators to outline the comours of a contractualapproach to the enforcement of seniority in sovereign debt. One suggestion. putforward by both Zerrelmeyer and Gelpern, is for senior creditors to enforce thepriority ostensibly granted to them by a sovereign debtor vis-a.-vis other juniorcreditors pursuant to a "third-party beneficiary" theory. Junior creditors wouldagree to subordinate their claims, and courtS might enforce the subordination,based on the theory that the junior creditors could be construed as beneficiariesof the financing from the senior creditOr.25 Another suggestion, first offered by\X1oOO, is to contractually require the sovereign to include senior creditors asparties in subsequent junior debt issues.26 If sovereign debtOrs began to includethese kinds of subordination arrangements in their debt contracts, one couldconceive of Elfio/~type injunctions that courts might grant to senior creditorsagainst a sovereign that later attempted to violate the terms of the earlieragreement. If a sovereign debtor that had agreed to subordinate any subsequentdebt failed to do so, a creditor could ask a court to enjoin the new issuance.

\'V'hile such remedies might conceivably discipline sovereigns and open theway for contractual enforcement of an absolute priority rule for sovereign debt,one concern is that the cure could be worse than the disease. There exists a realpotential for nightmarish disruptions to the payment system, and one can alsoimagine a multipucation of costly legal actions among creditors. In addition, thisstrategy would impose a continuous monitoring burden on the senior creditors.Because any subordination clause included in a creditor's contract with the

"26

Gulati and Klee, 56 Bus Law at 638 (cited in narc: 20).

Zeuelmc:yer, Tht umfor (1n Explitit SenioritJStmcturr in SovtTtign Debt (cited in note 18); Gelpern,53 Emory LJ at 1152-53 (cited in note: 18).

Philip R. Wood, The Law ofSubordinated Debt (Stre:et & ~hnl.'e:ll 1990).

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borrower could not bind a subsequent third-parry borrower who might beignorant about the priority arrangement, the senior creditor would be forced to

police the debtor to make sure that the sovereign included a subordinationprovision in each subsequent debt issuance.v

We do not mean to discou.rage these contractual innovations, which maybe the only realistic way fon.vard in the absence of a renewed effort on the partof major debtor and creditOr nations to introduce a sovereign bankruptcyprocedure. But it is important to recognize that the contractual approach bringsimportant risks which could be largely avoided under an expanded statutory debtrestructuring mechanism, as we now explain.

C. OUR PROPOSAL

The SDRM either ignores or does not satisfactorily address three criticalissues: (1) the absence of a coherent priority scheme; (2) the need for an interimfinancing strategy that refines and alters the role of the IMF; and (3) the need foran independent decisionmaker to oversee the sovereign bankruptcy framework.In earlier work, we have explained how an expanded sovereign bankruptcyframework might handle each of these issues.28

\'Vith respect to priority, the sovereign bankruptcy framework shouldinclude a straight f.Lrst-in-rime priority scheme, tOgether with voting proceduresthat call for absolute priority treatment-that is, the assurance iliat higherpriority creditOrs will be paid in full. and that any haircut will be aimed first atlower priority creditors. Under our proposal, priority would be based on thetime that the credit was extended, with the debt of any given year taking priorityover debt issued in a subsequent year. Based on this priority, the sovereigndebtor would divide its creditors into classes at the outset of a two tier votingprocess for restructuring the sovereign's debt. For the purposes of the first vote,the debtor would make a proposal as to how much of its overall debt would bedischarged-that is, how large the overall haircut to creditors would be-andsubmit the proposal to a vote of all creditors. 29 If a majority of all creditors

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If the priority ammgemem were somehow deemed to be binding on a subsequent crediwr, thehigher "due diligence" burden would fall on new lenders, who would nttd to determine what meslock of outstanding senior debts was before making a loon. Shan of setting up a central registerof scnior debt that could be easily accessed by new lenden this would ofren be an impossible task.

Bolton and Sked, 53 Emory LJ at 763 (cited in notc 5).

At first glance, it may appear mat thc first step vote would invariably lead to a 49 percent haircutunder a simple majority voting rule, since a bare majority of crediwrs would form a coalition wcut off the remaining creditors, thus increasing the likelihood of repa~'ffient for the winningcreditors. But rhe minimum winning coalition intuition only applies if there are numerous, same­sized classes of creditors. If there were only one large crediwr dass, for insunce, the class wouldpresumably agree to whatcver haircut opcimizcs its repayment, based on the sovereign debwr's

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approved the haircut, the debtor would submit a rescrucrnring plan outlining theproposed treatment of each class of credicors for a second, class-by-dass vote.JO

If the requisite majority of each class voted yes, the plan would be implementedaccording to its terms. In the event that one or more classes rejected the plan, onthe other hand, the court would reduce the creditors' claims in the amount ofthe agreed upon haircut, starting with the lowest priority creditors and workingup the priority hierarchy.

This two-step approach has several crucial virtues. Perhaps mostimportantly, it would clarify credicors' priorities outside of bankruptcy andsharply reduce the risk of debt dilution. Since credicors would know that anysubsequent bankruptcy would be governed by the fust-in-time priority scheme,the priorities would apply within and without sovereign bankruptcy. 31 Forsovereigns that actually invoked the procedure, the two-step voting structurewould provide a mechanism for pushing the parties cowards a resolution even ifbargaining broke down, much as the threats of liquidation or cramdown do inordinary corporate bankruptcies under US Chapter 11.32

The principal exception to absoluce priority in our sovereign bankruptcyframework comes with irs second key feature, interim financing. As withcorporate debtors under Chapter 11, our framework would provide fmt priorityfor interim frnancing in order CO counteract the debt overhang problem thatotherwise might discourage lenders from financing the restructuring process_Because of the risk that priority treatment would encourage overborrowing,however, we distinguish between two categories of loans. Loans to finance the

financial condicion. In the real world, the capital structure of a sovereign debtor will fallsomewhere between the twO extremes of numerous, samc-sized classes and a single giant class.The first stage vote will also be affected by other factOrs, such as the sovereign debtor's interest inseeking only as much of a haircut as is necessary, in order to preserve credibility and its access rosovereign debt markets after the bankruptcy.

Our proposal does not specify the required voting pcrcent~, as the vocing ruJe could be tailoredby each sovereign when the bankruptcy framework was adopted. But we speculate: that manywould require 2 two-thirds superm2joriry, as under US Chapter II. Bolron and Skeel, 53 Emory LJ at 797 (cited in note 5).

Sovereigns could, of course, still tty to game the system and dilute earlier debt by issuing debtwith very shon maturities as their finances dererior.:ued. They would have difficulty finding buyersfor such debt, however, beC2USC investors would know that their interests would be \\iped out ifthe sovereign debtor filed for bankruptcy before reparing the: new debt.

Under Bankruprcy Code section 1112(b), creditors can propose: that a case be convened to

Chaprer 7 in order to liquidate the debtor, and section 1129(b) provides a mechanism for"cramming" down a reorganizacion plan despite the objection ofone or more classes of creditors.11 USC §S 1112(b), 1129(b) (2000). Although sovereign debtors cannot be liquidated and theabsence of a liquidacion opcion makes cramdown difficult to implement, the two-ticn:d votingregime is designed to achieve a similar effect.

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sovereign's trade debt would be presumptively permissible,~J whereas some formof approval, such as from a majority of the sovereign's creditOrs would berequired for larger loans. This strategy would effectively cabin the size of interimloans. In addition to minimizing the risk of overborrowing, the limited interimfinancing would also reduce rhe impact on rhe IMP's budget if rhe ltvrFcontinued to serve as interim financer. 3ot

The final issue is who should oversee the sovereign bankruptcy framework.Unlike earlier proposals, which would vest authority in a panel of experts set upby a new or existing international organization, ow: proposal would pennitsovereign debtOrs to me their case in the bankruptcy or insolvency court of anyjurisdiction where the sovereign has issued bonds (currently, this is likely to

mean ew York, London, Frankfun, or Tokyo). Not only would judges bebetter decisionmakers than the experts selected by a bureaucratic process, butgiving sovereigns a choice would promote jurisdictional competition and, as aresult, further enhance the decision-making process. The competition would beloosely analogous to the benefits of venue choice for corporate debtors in theUS.

D. ApPRAISING ARGENTINA'S DEBT

RESTRUCTURING CHALLENGES

It took only rhree monrhs after a final futile attempt by rhe IMF to rescueArgentina in September 2001 followed by a desperate move by the Argentinegovernment to restructure its domestic debt, for Argentina to face the inevitableand declare a default on its foreign debt. At the same time, Argentina also endedits nearly decade long currency board experiment, resulting in a rapid andsubstantial depreciation of the peso, which precipitated a systemic bank run. Thenation's new government hastily responded with a general freeze on bankdeposits that lasted for over half a year, with devastating effects on the economy.The dislocation of the Argentine economy provoked by the default and itsaftershocks was so great that GDP contracted by 11 percent in 2002-with apredictable sharp increase in poverty and unemployment. Understandably, in themidst of an economic crisis of such magnitude and the associated politicalturmoil, external debt restructuring was not a priority for the Argentinegovernment in 2002. Creditors were also reluctant to initiate negotiations at a

For a description of the COntours of made debt financing, sec, for example, It-fF, TraJt Fillalla illFillandal Crisu: AutsJ,,"III oj K9 Imm (Dec 9, 2003), available online at<http://www.imf.org/6tttnal/np/pdr/CT/2003/eng/120903.pdf> (visited Feb 7, 2005).

Our earlier article comemplated th:u the L\1F would continue to play this role. See Bolton andSkeel, 53 Emory LJ 763 (cited in note 5). In Pan III of this Article, we propose a new StT:uegy forinterim financing mat entails a restructuring of the Th{f's role.

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precautionary steps to protect its assets~such as transferring funds to itsembassies through channels outside the banking system, and temporarilyrenationalizing the postal service to preempt the attachment of postal serviceassets abroad. While clearly disruptive, these steps have not, however, imposedsubstantial costs on Argentina as had been feared.

Predictions of advocates of a laissez faire approach have proved inaccurate,on the other hand, as to the likely ease and speed of the voluntary restructuringapproach. Argentina's experience in the three and a half years following thedeclaration of default on its external debt has, if anything, underscored thedifficulties and inefficiencies of a contractual approach, and provides support forthe more interventionist policy envisioned by the IMF under the SDR~L Indeed,nearly four years have passed and an incomplete restructuring agreement hasonly just now been secured. These nearly four years of delay are not entirelyattributable to the Argentine government's reluctance to negotiate. A first offerin September of 2003 to write off 75 percent of the nominal value of the debthad been flatly rejected by creditors as too low, especiaUy in light of thepromising signs of recovery of the economy in the early months of 2003. Afterthe coUapse of this first round of negotiations, creditors did nO( sit still. Manysmall holders of Argentine bonds, mainly based in Europe, organized themselvesunder the Global Committee of Argentina Bondholders ("GCAB")-abondholder committee seeking to represent dispersed bondholders in directnegotiations with the Argentine government.

Although a recent debt-swap offer has been accepted by a roughly 75percent majority of creditors, there have never been formal direct negotiationsbetween the GCAB or any other representative bondholder committee in thepast two years. 36 Indeed, with the strong backing of Argentine public opinionand a strengthening economy, the Kirchner government adopted a hardnegotiating Line and refused to make significant concessions on its first offer.Although Argentina's ability to repay its debts has significantly improved overthe past two years, its willingness to pay has if anything decreased. Most ofArgentina's costs of default had been incurred in 2002 and were sunk by thetime negotiations started. Neither the Argentine economy nor the governmentwas in urgent need of borrowing from international capital markets. \X!ith theGCAB insisting that Argentina's ability to repay should be the only criterion fordetermining the size of a reasonable haircut, there was Little room for a mutualunderstanding between the two parries.

Despite the tough stance taken by the Argentine government and its.decision to move forward with a new unilateral, take-it-or-Ieave-it, debt swapoffer, it still took considerable time to put forward a new proposal. There were

36 Adam Thomson, Argentina Seeks ta Ease CreditarCanum; on Debt ClauH, Fin Times 6 Oan 15,2(05).

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time when the economy and Argentina's perceived ability to repay its externaldebt were at their lowest.

While Argentina was undergoing the worst economic crisis in its history,commentators in the SDR1\tI debate sometimes pointed to Argentina as a testcase, which would vindicate advocates of a contractual approach ro sovereigndebt restructuring and show that it was possible to orchestrate a voluntary debtrestructuring successfully in a short period of time. Unlike the few prior cases ofsuccessful debt restructuring such as Pakistan, the Ukraine, and Ecuador, thesize and complexity of Argentina's external debt restructuring problem­involving multiple bond issues held by hundreds of thousands of creditors allover the world and adding up to nearly ninety billion dollars total face value ofdebt-would truly put the contractual approach to the test. Could a voluntaryrestructuring of such magnitude and involving so many creditors be completedsuccessfully in a reasonable amount of time? And could Argentina avoid fallingprey to holdout creditors and to the uncoordinated legal actions of multiplecreditor groups?

Advocates of a contractual approach argued that the risk of privatelitigation and the potentially disruptive consequences of court rulings in thewake of Elliott Associates v Pern were highly exaggerated. They predicted that noUS or English court would grant Elliott-type injunctions to Argentine creditors.They also maintained that once negotiations started and an offer was on thetable, the contracting parties would be able to reach a swift agreement withoutundue delays. The only source of delay, they maintained, was due to theArgentine government dragging their feet and refusing to initiate negotiations.Furthermore, a statutory mechanism for debt restructuring, as envisioned by theIM:F, would fare just as poorly in inducing the Argentine government to thenegotiating table.

Their predictions have only partially been borne out by events. The risk ofprivate litigation did indeed turn out to be less important than manycommentators had feared. There have been fewer lawsuits than expected and theUS District Court for the Southern District of New York in particular-whereseveral actions against Argentina have been brought-has shown considerablerestraint and willingness to first give negotiations a chance. The court has alsoruled in favor of Argentina in limiting creditOrs' ability to seize Argentine assetsin the US, such as Argentine military assets and Argentine payments to itsembassy.35 The same court had earlier certified a class action suit by a group ofcreditors and granted these creditors the right to attach Argentina's commercialassets worldwide. Partly in response to this ruling, Argentina had to take several

Angela Pruitt, US JudU Limits 5(opt ofDiscovery 011 Argenhtte Assets, Dow Jones Newswires (l'vfay 13,2(04).

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initial hesitations as to the form of the offer and the extent to which earlyadopters should be favored over later adopters to build in an incentive to acceptthe exchange.)1 The Argentine government had further difficulty in enlisting aninvestment bank to organize the debt exchange. And finally, following aworldwide road-show to advertise the exchange, Argentina still had to receivethe approval of a number of National Financial Regulators in countries like Italy,where a large number of small Argentine bondholders resided.

The successful completion of the recent swap is not due to Argentinacoming around to bondholders' demands. Rather, after sticking to its toughbargaining stance for nearly four years, Argentina has managed to wear down alarge fraction of creditors. Also, Argentina has benefited from a sharp decline inemerging market debt yields-an unexpected development that has produced asubstantial increase in the real value of the debt exchange.

At the time of writing it is not possible to say what will happen to theholdouts of the recent debt exchange. Will their bargaining position bestrengthened or weakened? \Xlill they prevail in court against attempts by theArgentine government to stay in default on those bonds? Thus, even afterArgentina's resounding victory in the latest debt exchange, it is still not dearhow successfully the voluntary debt restrucruring process will play our with thesignificant fraction of holdouts. Few observers would describe this experience asvindication of a laissez faire approach. It is even harder to describe Argentina'sdebt restructuring experience as particularly favorable to creditors. Bondholderscould hardly have obtained worse terms had the restructuring taken place undera more formal bankruptcy procedure such as that proposed by the SDR.J.\1. In alllikelihood they wouJd have secured a deal much sooner and under better terms.

In hindsight, the Argentine experience points to one major advantage of astatutory approach: it can be structured to keep the negotiating process movingforward by specifying hard deadljnes for offers to be submitted, as in Chapter11, and by structuring incentives for the parties to come to a quick resolution ofthe restructuring process. The Argentine experience also highlights that creditorscan be put -in a weaker bargaining position under laissez faire through a coerciveexchange offcr than they would be under a statutory procedure where finalapproval depends on some form of supermajority voting.

According to Dow Jones, me Argentine govanment e\'cntually d«idcd to abandon iniriaJ plansto include "~t consent" clauses in Argentina's debl-S\l,'ltP offer ItS It wltr of It...oiding pmc:ntialfuture litigation Itnd securing Itpproval of the pbn ~;lh some countries' fInancial regulators.A't.elltina uU'llgnQ: unftmu No Debt S,,-ap "Exit UtutnIJ", Dow Jonc:s Ne'\\'SWires (No... 5, 2004).

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III. TRANSFORMING THE IMF's ROLE AS A LE DER

OF LAST RESORT

The IMP's place in the international financial architecture is now moreuncertain than it has been since the coUapse of the Bretton \'(Ioods framework inthe 1970s. The size of the Fund relative to international fmancial flows and to

the stock of foreign reserves held by central banks around the world has beenshrinking to the point where it can no longer playa credible leadership role aslender of last reson for any but the smaller emerging market borrowers. As aresult, the Fuod has increasingly been drawn to focus on emerging marketcountries and to redefine its mission as one of macroassistance to developingnations and to poverty reduction-a role traditionally performed by the \VorJdBank. It is not clear whether the Fund has the expertise to fill this new roleeffectively, and there is a risk that it may end up being marginalized by theWorld Bank and other development aid agencies. But more impOrtantly, the newmission that has been pressed ooto the Th1F due to lack of funding is not themission that the Fund has been set up to pursue.

One obvious way of restoring the I1.\1F's original role, advocated by someG-7 countries, is co substantially increase the size of the Fund. But even if thisenlargement were feasible, the history of past interventions would still raisemajor concerns about the potential distortions large bailout packages canintroduce into sovereign debt markets. Another way forward, advocated byseveral leading economists, is to move in the opposite direction-further scalingback the size of the fund, phasing out IMF programs entirely, and confining the1J.\1F to a purely advisory role.38

We believe that neither of these two options is desirable. If the IMF wereno longer a major source of emergency lending for distressed sovereigns, asadvocates of a scaled back IMP propose, why should sovereign governments payany attention to itS advice? Even free advice would not be welcome, and theIMF would be doomed to irrelevance. More importantly, once the IMF exitedthe lending business, it could no longer play its role as catalyst to help resolveliquidity crises and debt panics. 39 The alternative solution, a much larger butunreformed and highly political institution, would give rise to moral hazard inlending and other distOrtions. Perpetuating the status quo is equally undesirable,since it would be equivalent to condemning the institution to a slow death.

38 Sec Rogoff, The Sisttrs aJ 60, Economist at 65 (cited in note 2); Chari and Kehoe, Asking the RightQMnlifJ1U aboJlt the IMF, Federal Reserve Bank of Minneapolis Annual Repon Issue (cited in note2).

Sec Giancarlo Coneui, Bernardo Guimal'2e5, and Nourid Roubini, lntemabimal Lmdint Dj LmRum alld MfJral Hazard; A Model of IMF's Calo!J1ir Finona, , BER \'(Jorking Paper No 10125 (Dec2003), available online at <http://pape~.nber.org/pape.rs/\V1012S.pdf>(visited Mar 20, 2005).

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This intuition is butrressed by the experience in Chapter 11 cases. The ex.isting empirical e"'idencesuggests that DIP financers are more likely to lend to debtors [hat have a significant chance ofsuccessfully reorganizing, than to more precarious firms. See, for example, Maria Carapeto, Does

Rather than any of these alternatives, we believe that the IMP's role shouldbe reconfigured in a very different way, as part of a sovereign bankruptcyframework that establishes an enforceable priority system for sovereign debt.The role we envision would strengthen the IMF's ability to act as an ILOLR inemerging market liquidity and confidence crises. It would also strengthen theIMF's hand in resolving sovereign debt insolvency crises. Yet it would notrequire any new public funding.

The proposal is quite simple. Instead of acting like a central bank thatprovides liquidity to a bank facing a bank run, the IMP would function like abankruptcy court charged with granting first-day orders and other DIPfinancing. In practice, not much change would be required in the way the IMPoperates. A distressed sovereign would still begin by approaching the Fund witha request for an assistance package. The size of the loan and its conditionalitywould still be negotiated between the Fund and the sovereign behind closeddoors. The loan agreement would still have to be approved by the IMP's Board.But under the new role we envision, the I1\1P would put together a fundingpackage that would include priority lending from the pr.ivate sector along with itsown funds and any other public funding it can assemble. Over time, the IMFwould need to rely on a greater and greater contribution from the private sector.

To secure this sovereign debt version of DIP financing, the negotiationsinevitably would involve the private sector as weD as the IMP, since few privatelenders are anxious to lend on a sight-unseen basis. In practice, the private sectorinvolvement would be an important benefit of the new model we envision.Currently, when a package is put together the private sector does not participatein the negotiations and essentially must take the deal the IMF has worked outwith the sovereign as a fait accompli. This process not only makes it more difficultto involve the private sector, but also encourages free riding by private lenderson the IMP's emergency lending. Under our proposed new system, privatelenders would be directly involved in the negotiations; private sectorinvolvement would thus automatically be tied to the rescue deal. Thecoordination between private lenders and the IN[F's role as ILOLR is animportant benefit of our framework.

Another important benefit of the new model is that it would gradually shiftfrom taxpayer to private sector money and would be subject to more and moremarket discipline. If the private sector viewed a proposed rescue package as justmore money down the drain, it would in all likelihood refuse to extend newlending even if the new loans had higher priority status. 40 Similarly, if the

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sovereign were a repeat offender it would, over time, have less and less access to

emergency lending and would risk being shut out of the international creditmarkets.41 The reason is simply that following each crisis the sovereign wouldhave accumulated a larger stock of still outstanding priority debt and would beless and less able to secure new DIP fInancing, particularly if, as we proposebelow, prior DIP loans have priority over any subsequent DIP financing. 42

While the new role we envision calls for a radical departure from existingpolicy, it would not fundamentally change the process by which the larger crisesare currently handled. Consider, for example, how the IMP managed SouthKorea's debt crisis in 1997. After a substantial rescue package was put tOgetheron December 3, 1997, it quickly became clear that the funds promised to theSouth Korean government would be insuffIcient. 43 The package had notadequately reassured markets, and banks continued to pull out of Koreansovereign debt, refusing to roll over their short-term loans, something they hadnever objected to doing in the past. Faced with an impending crisis, the Treasuryand Federal Reserve resolved as a last resort to convene a meeting with themajor lenders under the auspices of the New York Fed on December 22,1997,and managed to wring an informal agreement from those present to continuerolling over their loans.44 The only way the Treasury and Fed could entice thebanks to attend the meeting, and then to cooperate by agreeing to roll over theirloans, was moral suasion bolstered by the fear of a major financial crisis if banksrefused to follow the IMFs lead. As several commentators have observed, moralsuasion is a rather weak inducement to rely on in dealing with a crisis of theseproportions. It would be fooush to depend on such a policy to maintain

"

Debtor-in-Possession Financing Add Voillt? (unpublished manuscript, 2(03), available: online at<http://www.cass.ciry.ac.uk/faculty/mcarapeto/papers/DIPFinancing.pdf> (visited Mar 20,200S) (finding that debtors receiving interim financing more likely to reorganize); Sandeep Dahipet aI, DebJor-in,Posiession Fil/ancing ond BankmpJC) &sol/(Jion: Empirical Evidence, 69 J Fin Econ 259(2003) (same).

Our approach would not preclude debt reduction initiatives for Highly Indebted Poor Countries("HIPCs''). These initiatives would merely take a differem fonn. Instead of forgiving previouslygranted official multilateral debt, the international community would buy private debt in thesecondary market and then retire it.

See rext accompanying note 49.

A toral of fifty-five billion cloUars, of which twenty-one billion dollars was contributed by theJ1..fF, was promised the Somh Korean government. This represented rhe highest amount the IMFhad ever lent to a single counlI)' and exceeded the normal quota by a multiple of six. See Blustein,TlxChoIJening at 148 (cited in note 1).

Six US banks-Cicibank,J.P. Morgan, Chase, Bank of America, Bankers Trust, and Bank of NewYork-artended the first New York meeting, which kick-started a series of negotiations withinternational banks that eventually led to a rescheduling agreement of twenty-two billion dollars inshort-term loans in exchange. for a sovereign bond, with the Korean government on January 28,1998. Id at 177-20S.

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international financial stability. It is not difficult to imagine a different outcometo the Korean crisis, with some major banks deciding not to attend the !11eetingat the New York Fed for example, and others unwilling to go along with theIJ.VfF or unable to agree on how the cost of rolling over their debts should beshared.

Now imagine the same situation, but with the IMF wielding new powers togrant priority status to banks' new emergency lending. In contrast to thesituation at the time, under this new regime banks would have had an incentiveto attend the meeting, since this might have given them an opportunity to obtainhigher priority status for their new loans. The higher priority would have putthem in a stronger position than the banks that did not attend the meeting if therescue plan failed and Korea defaulted on its existing debts. In addition, forthose banks attending the meeting, the IMP would have been able to securetheir cooperation much more easily by granting seniority status to their newloaos. 45

WhiJe the potentially huge benefits of this new role for the IMF areobvious, there also are several porential concerns. A first issue is whether ahighly politicized institution like today's IMF would abuse its new powers andgrant priority lending too liberally. This was a constant worry in the early days ofChapter 11, with courts permitting debtors to drag Out cases for years, andgenerally deviating too easily from enforcement of absolute priority. 46 Thehistory of IMF bailouts suggests that similar problems could undermine theframework we have described unless the ability to grant priority status toemergency lending was constrained. One such constraint might be to requirecreditor approval of DIP loans, if the loans are beyond a certain size or involve ahigh proportion of new lenders.47

There is a delicate balancing here, however, as any approval required bycreditors before the DIP financing is granted could undennine the IMF's abilityto respond quickly and quietly to a crisis. Announcing to all creditors that asovereign is seeking their approval for new DIP financing is tantamount to

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Although the si.ze of the bank loans would often be quite large, there is no reason to suspect thatthis would jeopardize the fmancing process we propose. In ordinary corporate bankruptcy cases,bankruptcy courtS have overseen major loans-such as the $1.5 billion DIP loan to UnitedAirlines-without a hitch.

See for example Lynn M. LoPucki, The TroJ/ble with Chapter If, 1993 Wise L Rev 729(documenting the increased length of Chapter 11 cases).

The possibility of a creditor vote on financing in the c0qx>rate context is considered and critiquedin George G. Triamis. A Thu)ry 0/the RtgJllation 0/Dtbtor-in·Po$Jwion Financing, 46 Vand L Rev 901,91~16 (1993). Our previous anide proposed that financing in amounts sufficient to cover asovereign's trade debt should presumptively be approved, without a creditor vote. Bolton andSkeel, S3 Emory LJ at 808 (cited in note 5).

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Rrdengning the IntemotitJnoi under ofLAst &.tort Bolton & Skul

broadcasting the sovereign's financial distress to the world and may well domore harm than good. Therefore, unless the sovereign was alreaqy in default andhad suspended debt payments, and short of reforming the governance of theIMF, a mate practical protection would be to either put ex ante limits on thesize of DIP financing (such as a maximum percentage of outstanding debt) or toallow for the possibility that courts could reverse the priority status of the mostegregious foons of DIP fmancing ex post if the sovereign subsequently invokedthe bankruptcy procedures once again. This latter possibility would instill somemarket discipline on the DIP lenders and limit the worst forms of abuse of DIPfinancing-although at the cost of introducing additional uncertainty into thelending markets.4s

A second concern is whether a priority rule for sovereign debt could beenforced at aU. How would the IMP be able to enforce priority? How should arecalcitrant sovereign be dealt with? So far the liVfF has on the whole been ableto enforce the higher priority of ·its own funds. 49 The L\.1F's success can betraced to a major carrot and stick it can apply to enforce its priority staNS.Compliant sovereigns continue to have access to IMF programs at favorablerates, whereas a recalcitrant sovereign risks losing its membership and facingsome form of exclusion from sovereign debt markets. There is no reason apriori to expect that the IMF's enforcement powers would disappear if the loanwere made by the private sector with the IMF's blessing. But, should the stockof senior debt become so large that the sovereign might be tempted to defaultand to ignore the priority statuS in a restructuring. one could still enVisionenforcement of priority through the couns via Elliott-style remedies.

Third. what happens when a sovereign repeatedly runs intO financialdistress and accumulates senior loans from past DIP financing? \X1ouldn't newDIP financing risk diluting old DIP loans, if the sovereign debtor defaulted asecond or even third time on all its debt? And if this dilution werc anticipatedwouldn't it prevent the IMF from obtaining emergency lending from the privatesector? An obvious way of addressing these problems would be to make surethat past DIP loans had priority over current and fUNre DIP loans. In effect, thefirst priority DIP loans would themselves be subject to a first-in-time priorityregune.

Fourth, how would Paris Club and other bilateral government debt betreated? Ideally, Paris Club creditors would be subject to the same restructuringprocess as other creditors. It is unlikely, however, that sovercign lenders would

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Under US bankruptcy law, a court's initial decision on DIP financing generally cannot be rever.;edso long 2$ the credit was extended in good faiili--a protection that is justified as necessary toensure certainty. See 11 USC § 364(e).

See Zcttclmeycr. The Coufor aIt Explicit Stnioti!y Stl'1idurr in Stwtnign Dtbt (cited in note 18).

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agree to put themselves under the authority of the IMF or a sovereignbankruptcy regime. The most plausible approach for handling Paris Club debtwould be to treat it as a priority obligation. Although this poses the risk thatParis Club loans will dilute the interests of private creditors, one benefit is thepossibility that an alternative source of emergency lending to sovereigns wouldbe available that could serve the role of a safety valve in cases where the II\1Ffailed to intervene, perhaps for political reasons.

The final issue is implementation: What changes would need to be made torestructure the IMF's role as we have described? Advocates of sovereignbankruptcy have proposed a variety of implementation strategies. Onecommentator suggests that sovereigns could unilaterally adopt a sovereignbankruptcy regime. 50 Under this approach, a model law could be drafted byUNCITRAL or another international organization, and the legislatures ofsovereign debtor states could pass legislation based on the draft Jaw. In effect,the bankruptcy framework would set the parameters of the debtor's obligationsto its creditors. A second strategy would rely on treaties among the creditor anddebtor nations or a convention ratified by the legislatures of the various affectedcountries. Still another strategy centers on an amendment of the IMP's articles,which would require majority approval by the IMP and approval of three-fifthsof the Fund's members. 51 Members would then be expected to take appropriatesteps to implement the change under their domestic law. This third approach isthe strategy the IMF planned to use to implement its SDRM.52

We believe that the new role we envision for the IMF would not by itselfrequire af!Y of these changes. Since our proposal would simply reconfigure theEvIF's existing role-retaining I1vIF oversight while privatizing the lendingfunction-it should not require the IMF to go back to its members to ask fordifferent or additional authority. This suggests that the IMP could adopt thereconfigured role on an ad hoc basis, by negotiating a financing package thatrelies on private lending the next time it intervenes in a sovereign debt crisis. Inour view, the ease with which the proposal could be adopted is one of its signalattractions.

Christoph G. Paulus, A ugill Qrd{rfor 1,lJo/vencits 0/Statu 6-7 (unpublished manuscript), availableonline at <http://www.inwent.org/cf-texte/sdrm/paulus.htm> (visited Mar 20, 2005).

More precisely, amendment of the IMF Articles requires three steps: (1) the Execucive Boardvotes on a proposed amendment, and it is approved by a majority of those who vote; (2) theamendment is approved by a majority of the Board of Governors who vote; and (3) it is approvedby three-fifths of the members of the Fund, with at least 85 percent of the total vocing authority.See for example IMF, The Duign 0/ the Sovmign Debt Restructuring Mechonism----FuTther Considerationsat 275-82 (cited in note 11) (describing the amendment process).

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&designing Iht Inlffl'lational UndtT' ofLasl Ruort Bollon & SJ2tl

Adjusting the ThfF's role by itself, however. is an incomplete solution tothe shortcomings in the existing international financial archite~rore; mostimportantly, it would not address the need for a coherent, enforceable priorjryscheme-a need that we have stressed throughout the Article. But even in theabsence of a more complete reform such as sovereign bankruptcy. thereconfigured I1\JfF role offers twO hugely important benefits: it would addressthe IM"F's funding limitations and would bring the private sector into the heartof the debt restructuring process. More generally, the reconfigured role wouldpreserve the I~rfF's relevance for the sovereign debt markets of the new century.These benefits suggest that it would make sense to adopt the new approachnow. without waiting for more sweeping reforms such as implementation of asovereign bankruptcy regime.

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