The perils of (bond contract) faith

Mark Weidemaier and Mitu Gulati, of the Universities of North Carolina and Virginia respectively, frequently teach classes on sovereign debt together. They also host the podcast Clauses and Controversies.

To cure insomnia, read the fine print of a bond contract. For extra somnolence, check out its Definitions: dozens of pages of technicalities, all before the first provision.

A reader intent on staying awake might skip directly to the legal provisions, believing that, upon encountering a dreaded Capitalised Term, they can simply turn back to the Definitions to learn its meaning. Except that every Tenth Word of this Stupid Document turns out to be a Defined Term! Who has patience to keep flipping back?

The solution, for many, is to have faith. More specifically, faith that whoever drafted the contract defined its terms in standard or predictable ways. If definitions are always the same, why bother reading? Just skip it. Problem solved.

This reading strategy usually works. But occasionally, pitfalls lurk in that dullest of fine print. And as debt problems mount for sovereign borrowers, we are noticing some doozies in their bonds’ Definitions sections.

First, let us set the stage. Every sovereign debt restructuring today involves inter-creditor tension. Each creditor (Paris Club, local bondholders, foreign bondholders, syndicated lenders, Chinese state-owned companies, etc) worries that another will get better treatment. For example, if China’s Export-Import Bank lent to Suriname at below-market rates on the condition that Suriname hire Chinese companies, other creditors might worry that China Ex-Im will get a better deal in the restructuring.

To minimise this risk, bond contracts such as Suriname’s 2026 dollar bond contain equal-treatment clauses, where the borrower promises something like:

The Notes . . . will rank pari passu, without any preference among themselves and equally with all other unsubordinated External Indebtedness of the Republic.

Usually, External Indebtedness refers to debt denominated in a foreign currency (or, occasionally, debt held by non-residents, which is more likely to be denominated in a foreign currency). The logic is that, if the debtor runs out of foreign currency, it may want to favour some creditors over others. The equal treatment clause is designed to prevent this.

Since External Indebtedness typically refers to foreign-currency debt, a Reader of Faith might have skipped over the Definitions section of Suriname’s 2026 bond. That may have been a mistake. Here is how the section defines External Indebtedness:

“Indebtedness” is “actual or contingent payment obligations for borrowed money . . .”

“External” is “any Indebtedness issued and placed outside of the territory of the Republic . . .”

When is debt “issued and placed” outside the Republic? The term “issued and placed” (and where is the Definitions-section detail when you need it?) sounds like it was designed for multi-creditor instruments such as bonds and syndicated loans. But Suriname has other types of creditors as well. Let’s assume (hypothetically) that Suriname wants to resolve claims by holders of dollar bonds and by China Ex-Im, which also lent in dollars. And let us further assume the Ex-Im loan was finalised and signed in Suriname. Would it violate the equal treatment promise for Suriname to defer payments to Ex-Im by two years, while sticking the holders of the dollar bonds with a 30-per-cent haircut? Seemingly not.

What if Suriname were to pledge its gold reserves as collateral for the Ex-Im loan? Normally, this type of agreement would violate a bond contract’s Negative Pledge clause, which forbids the creation of new secured debt unless the debtor grants a similar security interest to existing creditors. But Suriname’s Negative Pledge clause limits the creation of security interests only when granted to secure “Public External Indebtedness”, which may not (hypothetically) include the Ex-Im Bank loan. Oops.

Turning elsewhere, Ghana, as of this writing, is trying to navigate between domestic and foreign bondholders. Initially, rumour had it that domestic holders would get off scot-free due to a combination of politics and fear that restructuring domestic debt would tank the economy. Now, it looks like domestic holders will suffer some substantial haircut, with certain groups (eg pensioners) getting better treatment. The remaining relief will come from foreign creditors.

Except that Ghana’s equal treatment clause reads:

The Notes . . . will rank pari passu . . . with all other present and future unsecured and unsubordinated obligations of the Issuer.

This clause, found in the 2021 Medium Term Note Program documents for foreign bonds, does not limit the equal treatment promise to External Indebtedness. The clause quite plainly seems to require Ghana to treat foreign bonds equally with all other unsecured debt.

Does this mean that treating domestic holders differently would violate the equal treatment promise? If so, could some angry (or sharp) foreign holder seek an injunction and threaten to bring down the entire restructuring plan? Such a tactic might have long odds of success, since Ghana’s bond contracts include language designed to protect the country from this tactic. But that language has not been tested in court.

Long story short: the broad equal-treatment provision complicates any attempt to distinguish between domestic and foreign creditors, and grants additional strategic options to holders of foreign bonds.

Did Suriname’s dollar bondholders know, in 2016, that they were agreeing to an equal treatment clause that might not cover some of Suriname’s (significant) bilateral borrowing? Did Ghana’s foreign bondholders know about the expansive scope of the country’s equal treatment promise? We can’t say. What seems clear is that readers who assume that sovereign bonds have standardised Definitions sections may learn that their faith was misplaced.