JURIST Guest Columnist Luis Vasconcelos is a LL.M. Candidate at the Católica Global School of Law, a Lisbon-based faculty of the Catholic University of Portugal. In this first entry of a four-part series on the realities and priorities of Portuguese sovereign debt management, Vasconcelos explains the legal constraints and enabling mechanisms of a voluntary Portuguese debt exchange…

Intense pressure and focus on Portugal’s public debt have followed Greece’s debt restructuring. Many correctly state that the Portuguese economy is not robust enough to bear its debt burden; therefore, the only way to ensure a successful end result is through some form of debt relief. Portuguese debt restructuring inevitably becomes an option, and, to that extent, Portugal can learn from the Greek experience. For Portugal, the core question is whether restructuring should be performed voluntarily or involuntarily. I emphasize the merits of the former approach, an option that would require the highest possible degree of creditor support. It is necessary to consider how a creditor-wide interest convergence can be made likely through available legal mechanisms.

The voluntary approach would work as follows: the Portuguese government would propose to its creditors an exchange of the existing bonds for new bonds that would be worth less, but would include better legal protections for creditors. Once the arrangement is voluntarily formed, there arises the immediate consequence of ensuring the continuity of debt servicing for the deal’s non-participants. This is a manifestation of the so-called “free rider problem,” elaborated upon by Mitu Gulati & Jeromin Zettelmeyer in Making a Voluntary Greek Debt Exchange Work [PDF]. Basically, large creditors, namely European financial institutions, may be interested in the exchange given their significant business involvement with Portugal and its official creditors. These entities value the sustainability and health of the Portuguese economy. On the other hand, the smaller investors, such as hedge funds, want to be paid as much as possible and tend not to have the same long term interest in the health of the nation’s economy. The problem is that about 77 billion euros of Portuguese bonds are held by this type of investor, and following Greece’s experience, more bonds are being acquired by these investors with the intent to obtain the highest possible exchange value. Additionally, even regulators will be tempted to allow the sale of bonds by large institutions to hedge funds in order to strengthen their balance sheets.

Two questions follow: how can we reconcile such contradictory aims? And what incentives do the agents have to accept a restructuring deal?

It is difficult to comprehend why a creditor would accept a new instrument that would be worth less than the original instrument if, simultaneously, the debtor has already committed to full payment on the original instrument. However, if three important constraints are introduced, the scenario appears in a dramatically different light. Suppose the debtor is suffering financial difficulties; the obligation must be re-paid only after five or ten years and, the debtor’s proposal, whether a haircut or a deferral of the payment date, might not be sufficient to bring financial stability nor is it certain that it would preclude the possibility of another debt restructuring in the near future.

In this case, the creditor may be interested in accepting a reduction provided that the creditor would be better protected than in the original agreement. In Portugal, according to Goldman Sachs’ Global Viewpoint [PDF], about 35 billion euros in bonds will mature between 2012 and 2013. Here, the free rider problem comes to the fore. This data could be interpreted to suggest that it would be a better solution to ask for 35 billion euros in aid from the official sector, rather than restructuring and attempting to recover in 2014 through the capital markets. However, this option also has consequences, as the longer restructuring is delayed, the bigger the haircut that is likely to be given. Irrespective of whether Portugal will be able to return to the markets in 2014, it should consider the possibility of a negative scenario, especially provided the increasingly apparent lack of faith in the Eurozone markets.

Turning to how the new instruments can be made more appealing vis-à-vis the originals, there is a relatively simple solution based on legal mechanisms. What the old instruments lack in creditor protection can be provided for by the new instruments. Much more expansive and more effectively drafted protection clauses can be incorporated regarding acceleration, cross-default clauses, negative pledges, etc. Furthermore, it is possible to give some legal priority to the new instruments without giving them pari passu protections, which would give creditors equal rights of payment. However, this scenario would be classified as an event of default under the terms and conditions of the credit default swap (CDS). However, it should be noted that if default is triggered, the severity of the consequences are debatable. For example, thus far, the Greek experience has shown that default can be triggered without involving great troubles.

With regard to Portugal’s debt, it is difficult to grant seniority to the new instruments since, under Portuguese law, one of the few creditor protections is the pari passu clause’s prohibition against more favorable treatment of some debt instruments relative to others. Therefore, it would be difficult to explicitly and legally make the old instruments subordinate to the new ones. However, there is a way out. Portugal could offer new instruments, with better creditor protections, including provisions for clauses related to modification, cross default, negative pledges, pari passu, foreign law, etc. This is to say that the Portuguese government could set up a much firmer contractual structure, giving more protection and certainty to creditors under the new instruments. Indeed, while explicit legal seniority of the new instruments would not be granted, in practice the new bonds would de facto be considered senior and would, therefore, be more appealing to creditors. Again, this will only work if creditors believe in the necessity of protracted restructuring.

There are, however, certain constraints to consider in light of the free rider problem. The main factors that would influence investor choice can be identified:

1. The probability of default on the original instruments: if default is unlikely, then the creditor would probably opt to stay with the old bonds, which is to say that receiving X is better than receiving X minus a haircut. On the other hand, if the possibility of default is high, then X minus default could be a worse option than X minus a haircut.
2. Short, medium or long term debt: it is unlikely that a creditor will accept an exchange for debt in the short term. However if the old debt is medium-long term, then it is subject to some default risk. By 2012, about 25 billion euros in bonds will mature. While those holding this 25 billion euros in bonds are not likely to accept an exchange, the majority of bonds are of medium-long term issue.
3. CDS should be taken into account in assessing investor incentives: in fact, if an investor has bought this kind of protection, he would prefer an involuntary restructuring to a voluntary one. Accordingly, the default scenario is favorably viewed by such investors, as they would obtain full payment. Concerning Portuguese debt, there are about 3900 CDS contracts covering a net 5.3 billion euros of outstanding Portuguese debt, as of March 18, according to the Depository Trust & Clearing Corp.
4. The likelihood of a new involuntary debt restructuring: as mentioned, newer debt instruments would include legal protections for creditors. Thus, if the creditors believe that there will be a new debt restructuring in the future, they will be tempted by instruments better equipped for crisis.

Considering this reasoning and data, there will be about 30 billion euros of debt that eventually will not be tendered. Thus, if we consider only the debt issued under Portuguese law to private investors, 53 billion out of 83 billion euros would be subject to the voluntary exchange, which would amount to a participation of about 64 percent of creditors realistically speaking.

A voluntary exchange would be more “pleasant” from any point of view. However, it may not be enough to fully transcend the Portuguese predicament, apart from being politically difficult.

At the end of 2012, the Portuguese total debt is estimated to reach 198 billion euros, 118 percent of the GDP. Supposing the aim to reduce the debt to 100 percent of the GDP, to about 168 billion euros, a reasonable value considering that Greece’s debt was at 120 percent at the time of restructuring, this would correspond to a reduction of 30 billion euros.

About 30 billion out of 83 billion euros of debt issued under Portuguese law to private investors would not enter in the exchange for the reasons mentioned above. Thus, the voluntary exchange would be limited to only 53 billion euros worth of bonds, which will have to suffer a reduction of 56 percent provided the aim of reducing the debt to 100 percent of the GDP.

This reduction is highly burdensome for investors accepting the voluntary exchange. The markets may not see it as a fair deal, and could further obstruct Portugal’s hope for recovery. However, the outcome of this exchange would give unprecedented protection to Portuguese creditors. Investors will only take this advantage if they perceive a high level of uncertainty regarding the full payment of the old debt instruments, or a high possibility of an involuntary restructuring in the future.

In “Making a Voluntary Greek Debt Exchange Work,” Mitu Gulati and Jeromin Zettelmeyer have said that,
“[i]ronically, it is the lack of faith of the market that a reduction of the Greek public debt ratio to 120 percent is enough to make Greece’s debt sustainable that may help to make Greece’s latest plan to work.”

The irony for Portugal is that its situation has not reached that of Greece’s, and that is why a voluntary exchange is much more difficult to achieve here in the present.

Luis Vasconcelos holds a Diploma in Law from the Catholic University of Portugal, and he specializes in Banking and Finance Law. Following his LL.M. studies, Vasconcelos will serve Lisbon-based CARDIGOS as a trainee lawyer.

Suggested citation: Luis Vasconcelos, Realities and Priorities of Portugal’s Debt Management, Pt. I, JURIST – Dateline, Mar. 22, 2012, http://jurist.org/dateline/2012/03/luis-vasconcelos-portugal-debt.php.