Inside the Black Box: How Should a Sovereign Bankruptcy Framework Be Structured?

Abstract

For at least two decades now, commentators have suggested that international policymakers should establish a sovereign bankruptcy regime. In 2002, the debate intensified when the International Monetary Fund (IMF) explicitly endorsed the sovereign bankruptcy concept, and offered a detailed proposal for what the Fund refers to as a "Sovereign Debt Restructuring Mechanism."

In this Article, we consider the arguments in favor of sovereign bankruptcy, assess the IMF's SDRM, and develop our own sovereign bankruptcy framework. Perhaps the single most important theme of our analysis is the importance of promoting adherence to absolute priority wherever possible. Contrary to much of the criticism of sovereign bankruptcy, which worries that this approach would seriously undermine creditors' entitlements, we argue that sovereign bankruptcy can actually assure greater adherence to absolute priority than the status quo. Because it is often impracticable to lend to sovereigns on a collateralized basis, creditors currently have great difficulty assuring that their priorities will be honored. Even ostensibly collateralized obligations, moreover, may not guarantee priority treatment, as evidenced by the subversion of priorities when Ecuador restructured its debt in 1999.

We argue in this Article that the classification and voting rules of a sovereign bankruptcy regime can be used to address this problem. As a baseline, we propose that the SDRM or other framework enforce strict, first-in-time absolute priority. Bonds issued first would have priority over those issued later. The only exceptions to first-in-time priority would involve trade debt (which would always be treat as a priority obligation) and collateralized lending (which would be given priority treatment under some circumstances). Against this backdrop, we propose a two step classification and voting process for confirming a restructuring plan. The debtor would first make a proposal as to how much its overall debt would be scaled back - that is, how large the overall "haircut" to creditors would be. If a majority of all creditors approved the haircut, the second step would simply entail reducing the creditors' claims in this amount, starting with the lowest priority creditors and working up the priority hierarchy. This two step approach not only would reinforce the creditors' priorities within the SDRM; it also would clarify their priorities outside of the restructuring process.

The Article proceeds as follows. Part I explores the principal alternatives to sovereign bankruptcy - collective action provisions and the status quo - and explains why neither is an adequate substitute for an SDRM. In Part II, we provide a brief overview of the IMF's current proposal, and note some of its principal shortcomings - most importantly, its inadequate consideration of the SDRM's ex ante effects. Parts III-VII then develop our proposal. Part III takes up the question whether to impose a stay on litigation. Part IV then gets to the heart of the SDRM, and outlines the classification and voting scheme. Part V addresses the issue of interim financing. In Part VI, we argue that oversight should be vested in existing bankruptcy and insolvency courts. We then complete the discussion by discussing opt-out in Part VII, and tie the analysis together with a brief conclusion.

Keywords: Bankruptcy, sovereign bankruptcy, bankruptcy framework, sovereign debt restructuring mechanism