Realities and Priorities of Portugal's Debt Management, Pt. II Commentary
Realities and Priorities of Portugal's Debt Management, Pt. II
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JURIST Guest Columnist Rafael Lomenso is a LL.M. Candidate at the Católica Global School of Law, a Lisbon-based faculty of the Catholic University of Portugal. In the second entry of a four-part series on the realities and priorities of Portuguese sovereign debt management, Lomenso argues that Portugal is well suited for an extensive voluntary restructuring of a less intrusive kind than that recently performed in Greece…


My intention is to propose a fifth alternative to the four well-known paths available to the Portuguese government in response to its sovereign debt situation: (i) full default; (ii) full payment to its creditors, financed by official lenders; (iii) voluntary exchange, or (iv) an adaptation of Greece’s restructuring model, as set out by Mitu Gulati and Jeromin Zettelmeyer in Engineering an Orderly Greek Debt Restructuring.

I will focus on the possibility of restructuring and debt reduction without passing any judgment on the likelihood or even necessity of this debt management type. My proposal is an intermediate position, found between option (iii) of relying exclusively on a voluntary exchange of Portuguese bonds, and option (iv), a Greece-type restructuring.

Portugal is uniquely positioned to accomplish a successful voluntary exchange and impose a haircut, while simultaneously avoiding an event of default qualification. My claim is that the recent events in Greece and the haircuts imposed on local law bonds, if allied with exit consents, create strong incentives for Portugal’s creditors to agree to a voluntary exchange. Under these circumstances, bondholder objections would actually appear irrational.

The proposal would not affect residual debt issued under foreign law, since as the Goldman Sachs’ Global Viewpoint [PDF] has suggested, over 90 percent of Portuguese sovereign bonds were issued under Portuguese law, as was the casein Greece. These local law contracts do not contain collective action clauses, enabling Portugal to reach the same outcomes achieved in Greece. In short, Greece passed a law imposing on all past bond issues a collective action clause with low voting requirements for changes in the amount of principal due. Once a bondholder majority was reached, a decision agreeing to the haircut was binding upon each of the remaining bondholders via the collective action clause. The problem is that a binding change on the amount of principal due is formally considered an event of default for credit default swap purposes according to section 4.7(a) of the Credit Derivatives Definitions of the International Swaps and Derivatives Association (ISDA).

The idea is to implement the same measures utilized by Greece: to retrofit a collective action clauses with a 2/3 voting requirement of bondholders, or less if needed, and to change any provision of the treasury bonds, barring any constitutional issues. Ideally the clause would not be activated and would function only as a coercive tool, while exit consent would function as an added incentive to join the voluntary exchange.

With the law in place, a limited voluntary haircut on private bondholders should be made. The offer would entail an exchange of current local law bonds for foreign law bonds, with a restricted haircut on the principal—in order to reach an acceptable debt to GDP ratio. The trade would be conditioned by exit consents, and would specify voting rights within a month after the offer. Those voting rights would possibly be used in the future to impose a binding haircut on the old bonds, superior by a margin of 10 to 20 percent to the voluntary exchange offer. The exit consent consists in the bondholders assigning their voting rights over the old bonds to a third party, an exchange agent, in order for that entity to vote collectively on that bond before an exchange is made. There is certainly a legal risk involved in this untested method, but as applied to corporate bonds, the method has heretofore withstood litigation. And there should not be any legal complications regarding the pari passu clause, present in the Portuguese local law bonds, since newly issued bonds are instruments different from their predecessors, and no equality between them can be claimed.

Given this framework, the likelihood of a binding restructuring becomes high and the bondholders of local law bonds would have strong incentives to agree on a voluntary exchange. Each bondholder at this moment is faced with two options in this overlapping month in which the offer stands and no collective action clause has been used. A bondholder could either agree to the voluntary exchange and to a limited haircut, receiving a foreign law bond that would prevent future unilateral coercion, or hold out and receive a bigger haircut via the collective action clause enabled by the exiting votes concentrated in a single entity. At that point the bondholder’s rational choice would be to agree to the voluntary exchange. A few, however, would have an interest in legal action, including those bondholders whom currently have a CDS on their assets. The former should represent a small percentage of bondholders, but the latter’s options must be analyzed more deeply.

In order to force CDS holders to agree to an exchange, the deal must not cause an event of default with the triggering of the CDS, or the bondholders would holdout to for full payment.

The ideal solution would be a way to make use of the collective action clauses and make the bonds worse off without being considered an event of default under section 4.7(a) of the ISDA’s Credit Derivatives Definition. It would have to be a change substantial enough to persuade bondholders to accept a haircut in a voluntary exchange in order to get better protection in the newly issued foreign law bond. However, there are hardly any protections to take away in the current bond under local Portuguese law, so that scenario seems unlikely.

The optimal result then would be to ultimately not use the voting rights acquired and pay the holdouts, provided they are all CDS holders. In this scenario most of the private bondholders would have agreed to the exchange once faced with the choice explained above, and eventually only the CDS holders would have the incentive to holdout. On the other hand, CDS arguably has a limited impact of 5.3 billion euros, according to the Depository Trust & Clearing Corporation, of Portuguese outstanding debt with hardly any exposure of Portuguese banks in this market, so avoiding the event of default because of the CDS might be too costly if it means less trust from capital markets.

In our ideal restructuring, all non-CDS owners participate and do not resort to the collective action clause, and no formal event of default takes place. However, this has the disadvantage of creating mistrust in the bondholders that agreed to the exchange, and any kind of restructuring entails the substantial costs of providing liquidity for banks. This is especially a problem for Portuguese banks, which are heavily exposed to their own country’s sovereign debt, and thus require reinforcement of Tier 1 capital in order to satisfy capital requirements. Thus, this is not a clear solution to the problem of Portuguese debt, but another topic for discussion.

The common argument against any kind of restructuring is the impossibility to return to capital markets for financing in the future, but that outcome is lightly assumed and not necessarily backed empirically. It is merely an assumption on the willingness of an investor to trust a country after that country cheated. It is just as plausible that once reforms are in place and bring in a strong surplus, investors might be attracted by higher yields and, accordingly, be willing to invest in a growing economy if it issues foreign law bonds in a secure arrangement. I am not advocating that either assumption is correct or incorrect, only that Portugal should carefully study both in order to follow the best possible course through its debt recovery.

Rafael Lomenso holds a Diploma in Law from the Catholic University of Portugal, and he specializes in Banking and Finance Law. Following his LL.M. studies, Lomenso will serve the Lisbon office of Cuatrecasas, Gonçalves Pereira as a trainee lawyer.

Suggested citation: Rafael Lomenso, Realities and Priorities of Portugal’s Debt Management, Pt. II, JURIST – Dateline, Mar. 29, 2012, http://jurist.org/dateline/2012/03/rafael-lomenso-portugal-debt.php.


This article was prepared for publication by Megan McKee, the head of JURIST’s student commentary service. Please direct any questions or comments to her at studentcommentary@jurist.org


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