The Judgment-Holder Problem in Sovereign Debt Workouts

Abstract

Sovereign bond restructurings depend on collective voting mechanisms called Collective Action Clauses (CACs) in bond contracts. CACs let a bondholder supermajority modify the bond and bind dissenters to the outcome. But what if dissenters can avoid being bound by rushing to court and getting a judgment? Existing analyses suggest that the legal doctrine of merger and bar might cause the CAC to “merge” into a court’s judgment, effectively allowing judgment holders to escape the restructuring. Other bondholders would be unable to stop judgment holders from enforcing their judgments. Policymakers have long worried that this risk might undermine the contractual architecture for restructuring sovereign debt obligations. That concern also has prompted the U.S. and other governments to intervene in extraordinary ways in recent sovereign debt litigation.

We consider whether a judgment indeed has this effect. We begin by dispensing with the doctrine of merger and bar — it is largely irrelevant — and instead focus attention on two issues. First, we explain that a modification vote under the CAC cannot affect the previously-entered judgment of a federal court. To that extent, observers are right to worry that judgment creditors will escape the effect of a sovereign debt restructuring. However, we also explain that, while they cannot modify a court’s judgment, a bondholder majority or supermajority still can modify the bond to impair a judgment holder’s ability to enforce a judgment. Using Venezuelan sovereign debt as an example, we illustrate how this might work and highlight legal risks. We conclude that, although the risk is not zero, the existing contractual architecture includes tools for dealing with any risk posed by judgment holders.

Keywords: sovereign debt, venezuela, collective action clauses, judgments

JEL Classification: H63, F33, F34