Puerto Rico and the Netherworld of Sovereign Debt Restructuring

By G. Mitu Gulati (Duke Law School) and Robert K. Rasmussen (University of Southern California Gould School of Law)

Puerto Rico has incurred debt well beyond its ability to repay. It attempted to address its fiscal woes through legislation allowing the restructuring of some its debt. The Supreme Court put a stop to this effort, holding that Congress in the Bankruptcy Code barred the Commonwealth from enacting its own restructuring regime. Yet all agreed that the Bankruptcy Code did not provide anything in its place. Congress quickly passed the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) in an attempt to address Puerto Rico’s fiscal ills by enacting a special proceeding to deal with Puerto Rico’s financial woes. The price Puerto Rico paid, however, was steep—the imposition of a control board to direct, in effect, the Commonwealth’s finances and any insolvency proceedings. In light of the conditions that gave rise to PROMESA, we explore whether, in the first place, Congress has the power to bar Puerto Rico from enacting a restructuring mechanism without offering an alternative. We submit that the answer is no. When it comes to a state, the Supreme Court has held the power to issue debt necessarily implies the power to restructure that debt. Congress can preempt that power so long as it puts something in its place. To preempt and leave nothing runs afoul of our federal system. The same reasoning, with even greater force, applies to Puerto Rico. The federal government entered into a compact with the citizens of Puerto Rico, granting them, among other things, the power to issue debt. Puerto Rico implicitly received the power to restructure this debt. Congress could offer a substitute to any regime that Puerto Rico might enact, but it cannot leave the Commonwealth without any means to address its fiscal affairs.

The full paper is available here.

For previous Roundtable coverage of Puerto Rico’s debt crisis, see “Puerto Rico Update: White House Weighs in with a Proposal,” “Puerto Rico Public Corporation Debt Enforcement and Recovery Act,” and “U.S. District Court Holds that Puerto Rico’s Recovery Act Is Unconstitutional.”

Sovereign Bankruptcy Hydraulics

By Stephen Lubben (Seton Hall University School of Law)

The frequent suggestion that the world needs a sovereign bankruptcy mechanism is puzzling.   What precisely would be gained?

The core of any insolvency system consists of a stay against creditor action, an ability to recover preferential payments, and an ability to revamp the debtor’s operations by rejecting burdensome contracts and selling assets. These features, however, are largely irrelevant to sovereign debtors.

In the event of insolvency – or, more simply an inability to pay – sovereign debtors have four tools at their disposal. First, the sovereign might hide behind its immunity, by refusing to be sued. Or the sovereign might change its own law applicable to the debt. That might violate norms, but the sovereign who does this probably also controls the remedy for violations of such norms. Third, the sovereign might manipulate the currency in which its debts are paid. There are economic consequences to doing this, but they might be preferable to a formal default.

These first three tools comprise the modern concept of “sovereign immunity.” But a discussion of sovereign debtors must include a fourth, related issue: the ability to shield assets from collection. That is, even if the debtor can be sued somewhere, in some court, a judgment might be worthless.

If a government issuer can employ some or all of these mechanisms, it has little need of a bankruptcy mechanism because it can refuse to pay its debts, or it can negotiate with creditors to restructure the debt on its own. Kings and queens of old had no need for a bankruptcy mechanism because they could use all four of these tools. They would pay when they felt that paying was worth it, such as when they needed more funds from lenders.

Of course, there are differing forms of “sovereign immunity.” Few sovereigns retain full, old-fashioned sovereign immunity. Today, many emerging market borrowers and all American municipalities lack access to the first three tools. Their ability to avoid paying turns on the fourth tool, which they can deploy with varying ability.

In short, sovereignty and sovereign immunity occur along a continuum, and the need for a bankruptcy system to address financial distress varies inversely with a sovereign’s place on the continuum.

My short paper, Sovereign Bankruptcy Hydraulics, forthcoming in NYU’s Annual Survey of American Law, examines this basic dynamic and its implications for the insolvency of sovereigns and semi-sovereigns.

The Role of the Court in Debt Restructuring

By Jennifer Payne (Oxford University)

This paper examines the intervention of the law, and the role of the court, in debt restructuring, both in terms of imposing constraints on creditors and in seeking to ameliorate the potential abuses that can arise from such constraints. Three potential forms of abuse are examined: the imposition of a restructuring on dissenting creditors, which introduces the potential for wealth transfers between creditors; the imposition of a moratorium while a restructuring is negotiated, which might lead to misuse of the process by managers wishing to prop up companies that are not viable or may allow the managers of a viable business to “shake off” liabilities that the business is capable of servicing; and the imposition of debtor-in-possession arrangements, which raise the potential for new creditors to be preferred at the expense of existing creditors.  It is argued that the court’s role in protecting creditors from these three forms of potential abuse is vital, although the nature of that role differs according to the form of abuse. Recent debt restructuring reform proposals in both the UK and the EU, which adopt quite different approaches to the role of the court in this process, are examined in the light of this discussion.

The full paper is available here.

The Avoidance of Pre-Bankruptcy Transactions: A Comparative and Economic Approach

By Aurelio Gurrea-Martínez (Harvard Law School and Ibero-American Institute for Law and Finance)

Most insolvency jurisdictions provide several mechanisms to reverse transactions entered into by a debtor prior to the commencement of the bankruptcy procedure. These mechanisms, generally known as claw-back actions or avoiding powers, fulfill several economic goals. First, they act as an ex post alignment of incentives between factually insolvent debtors and their creditors, since the latter become the residual claimants of an insolvent firm but do not have any formal control over the debtor´s assets while the company is not yet subject to a bankruptcy procedure. Therefore, the existence of these mechanisms allows the prevention or, at least, reversal of opportunistic behaviors by factually insolvent debtors. Second, the existence of avoidance actions may also prevent, at an early stage, a destructive race to collect. Third, these legal devices also minimize the overinvestment problems potentially faced by insolvent debtors. Fourth, the existence of avoidance powers may encourage managers to take corrective actions in a timely manner. Finally, the existence of avoidance actions may also protect the interests of both the debtor and its creditors as a whole when some market participants want to take advantage of a distressed debtor.

However, the use—and even existence—of avoidance actions is not costless. On one hand, such actions bring litigation costs. On the other hand, the existence of these provisions may be harmful for legal certainty, especially in those countries in which bad faith is not required to avoid a transaction and the “twilight period” may be too long.

In a recent paper, I discuss how insolvency legislators should deal with this trade-off. Namely, by providing an economic and comparative analysis of avoidance actions, I discuss the optimal way to design claw-back actions across jurisdictions, taking into account the costs and benefits potentially generated by these provisions.

The full paper is available here.

Contracting for a European Insolvency Regime

By Horst Eidenmueller (Oxford University)

The European Commission has proposed a directive on “preventive restructuring frameworks” for financially distressed firms. If adopted, the directive would force the Member States of the European Union (“EU”) to design restructuring proceedings that conform to the directive’s stipulations.

In a recent paper, I demonstrate that the proposal is flawed because it creates a refuge for failing firms that should be liquidated, because it rules out going-concern sales for viable firms, and because it is, in essence, a twisted and truncated insolvency proceeding. I also demonstrate that the Commission’s harmonization plan is misguided. If implemented, financing costs for firms would rise. The plan would cast in stone an inefficient restructuring framework on a European-wide scale, preventing member states from experimenting with more efficient procedures.

I suggest an alternative regulatory proposal: European firms should have the option to choose a “European Insolvency Regime” in their charter. This regime should be embodied in a European regulation, guaranteeing legal certainty to stakeholders. This proposal would preserve horizontal regulatory competition between the Member States for the best “insolvency product,” and it would introduce vertical regulatory competition between the member states and the EU in the field of insolvency law. Hence, my proposal would strengthen market testing of European insolvency regimes instead of eliminating creative discovery processes through a flawed harmonized framework.

Key design principles of the proposed optional “European Insolvency Regime” are the following: (i) it should be open for restructurings, going concern sales, and liquidations, and firms should be channelled into the appropriate process based on the opinion of a court-appointed supervisor; (ii) it should be a fully specified (complete) and fully collective insolvency proceeding; and (iii) the proceeding should be conducted in DIP form with the mandatory appointment of a supervisor who performs important insolvency-related functions.

The full paper is available here.

The Future of UK Debt Restructuring

By Jennifer Payne (University of Oxford – Faculty of Law)

In the UK, a number of different mechanisms exist which can be used to restructure the debt of viable but financially distressed companies. This paper assesses the debt restructuring mechanisms currently available to companies in English law and considers whether reform is needed. In particular, the paper analyses the reform proposals put forward by the UK Insolvency Service in July 2016, which recommended: (i) the introduction of an option to cramdown whole classes of creditors using a single restructuring mechanism (something which can only be accessed at present using a scheme of arrangement combined with administration); (ii) the introduction of a restructuring moratorium akin to that which is attached to administration at present, together with a new ability for companies to prevent creditors with “essential contracts” from terminating them on the basis of insolvency alone; and (iii) the introduction of provisions designed to facilitate debtor-in-possession financing, something notably absent from the current UK regime. These reforms will need to be introduced with skill and care in order to ensure that the potential benefit they can bring to financially distressed businesses is balanced appropriately with the constraints that they impose on existing creditors’ rights. The aim of the Insolvency Service’s proposals is laudable, and it is argued that reform of the UK regime is needed. In particular, the introduction of a restructuring moratorium and a cramdown facility would be beneficial. Making these changes would provide English law with a stronger and more effective debt restructuring procedure. Furthermore, such changes are required if the UK wants to remain competitive in a global market.

The full article is available here.

The Sun Is Setting: Is It Time to Legislate Pre-Packs?

By John Wood (Lancashire Law School, University of Central Lancashire)

In the UK, pre-packaged administrations (“pre-packs”), while few in number, receive widespread attention due to the controversial outcomes that they often produce. The pre-pack process seems to have gained much exposure in recent years, but it is by no means a new concept. The negative reputation that pre-packs have resides with the lack of transparency that surrounds the process, in addition to connected parties purchasing the old company. Such an outcome leaves many creditors frustrated with both the lack of information received and the diminutive monies recovered for what they are owed.

Due to the sustained criticism of pre-packs, the British government reviewed the process to detect weaknesses in the UK’s company law framework and to ensure that the UK remained a competitive and attractive place to conduct business. This led to the Graham Review (“Review”), which made six recommendations that have since become somewhat essential to the survival of pre-packs as a non-legislative procedure. Ministerial pronouncements have put the profession on notice that, unless they take proper steps to produce substantial compliance with the Review’s findings, then legislative power will be exercised. While no further action has been taken, the Review appears to have attracted widespread support. The Review proposes non-legislative action, but the article examines whether, over time, legislation will become inevitable. What is therefore required is a balanced evaluation and critique of the Graham proposals—one that is capable of providing some form of yardstick against which to test the quality of any legislative initiatives which may be taken in the future.

The full article, published in 67 Northern Ireland Legal Quarterly 173 (2016), is available here.

The Dubai World Tribunal and the Global Insolvency Crisis

By Jayanth Krishnan (Indiana—Bloomington)

In 2009, as markets from the United States to Europe to the Global South shook, one country—the United Arab Emirates—found itself on the brink of economic collapse.  The U.A.E’s Emirate of Dubai was contemplating defaulting on $60 billion of debt it had amassed.  Recognizing that such a default would have cataclysmic reverberations across the globe, the government of Dubai turned to a small group of foreign consultants for assistance.  The resulting legal experiment demonstrates how aspects of American corporate bankruptcy law can be imported into and prove useful in the context of a foreign legal tradition. During the crisis, insolvency lawyers from the U.S. law firm of Latham & Watkins, analysts from the New York-based investment bank Moelis, and accountants from PwC – together with local domestic counterparts and experts from the U.K.– devised a highly sophisticated plan that helped the Emirate address the economic crisis in which it found itself.  As part of this plan, Chapter 11 and Chapter 15 principles from the U.S. Bankruptcy code, the 2/3 cram down technique on hold-out creditors, and an Anglo-American insolvency tribunal were introduced into Dubai in order to bring about economic stability and handle the highly complex cases that arose during the financial crisis. By respecting and interpreting U.A.E. law, the tribunal has maintained its legitimacy in the eyes of the Dubai government even as it has drawn on Anglo-American insolvency concepts.

On December 13, this study will be formally presented at a public event in Dubai by Indiana-Bloomington’s Center on the Global Legal Profession, where insolvency experts and policymakers from the U.S., Dubai, and the U.K. will be present.

The full article can be found here.

Restructuring Sovereign Debt after NML v. Argentina

By Lee C. Buchheit (Cleary Gottlieb Steen & Hamilton) and Mitu Gulati (Duke University School of Law)


The decade and a half of litigation that followed Argentina’s sovereign bond default in 2001 ended with a great disturbance in the Force. A new creditor weapon had been uncloaked: The prospect of a court injunction requiring the sovereign borrower to pay those creditors that decline to participate in a debt restructuring ratably with any payments made to those creditors that do provide the country with debt relief. For the first time holdouts succeeded in fashioning a weapon that could be used to injure their erstwhile fellow bondholders, not just the sovereign issuer. Is the availability of this new weapon limited to the aggravated facts of the Argentine default or has it now moved permanently into the creditors’ arsenal? Only time (and future judicial decisions) will tell. In the meantime, however, sovereigns will occasionally find themselves in financial distress and their debts will occasionally need to be restructured. Venezuela already casts this chilly shadow over the sovereign debt market. If, in a galaxy not too far away, sovereign debt workouts are to have any chance of an orderly completion, a method must be found to neutralize this new weapon.  Judging by the secondary market prices of different series of Venezuelan sovereign bonds, large amounts of money are being wagered that this cannot be done.

Argentina’s holdouts argued that they must be paid in full if Argentina wanted to make any payments to the creditors that accepted the country’s restructuring offers in 2005 and 2010. Those creditors had accepted a roughly 75 percent haircut in the value of their claims. But the holdouts were not offering to share with those old creditors any portion of a preferential recovery that the holdouts might be able to extract from Argentina. Why? Because the bonds that had been tendered in the restructurings of 2005 and 2010 had been canceled. The clause in those instruments that the holdouts now pointed to as the basis for their demand for a “ratable” payment whenever Argentina made a payment to its restructured lenders had been extinguished in the bonds previously held by those old lenders. So no contractual basis existed for the old creditors to assert a reciprocal claim against the holdouts.

It didn’t have to be this way. A future workout of New York law-governed sovereign bonds could be structured so that any bonds tendered by participating creditors are kept alive in a kind of deep freeze, available to assert a reciprocal claim against any holdouts who subsequently extract a preferential recovery from the sovereign issuer. The sauce that is flavorful for the goose thus becomes an equally suitable condiment for the gander.

The full article may be found here.

When Do Laws and Institutions Affect Recovery Rates on Collateral?

By Hans Degryse, Vasso Ioannidou, Jose Maria Liberti, and Jason Sturgess

The effect of bankruptcy laws and institutions governing enforcement on firm borrowing, investment, and growth has been studied extensively in the economics and finance literature using mainly country-level data. Due to the lack of micro-level data, the same literature has been silent on the underlying economic channels through which weak laws and institutions affect debt contracting.

In order to fill this gap, we study how laws and legal institutions that shift bargaining power between creditors and debtors in the event of default affect expected recovery rates on assets pledged as collateral in secured lending transactions. In particular, we study empirically the determinants of expected recovery rates on different types of collateral using a detailed loan-level dataset of secured loans made by a single bank across emerging market countries. We are able to pin-point the actual mechanism through which better law and stronger enforcement of secured loans can translate into lending: the effect of creditor rights and asset types on the bank’s expected recovery rates.  Our results suggest collateral that is movable (machinery, equipment, inventory, and accounts receivable), more asset specific, more susceptible to agency concerns, or faster to depreciate exhibits lower expected recovery rates since they are more vulnerable to laws and institutions.

For the full article, please click here.

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