Collective action clauses in the euro area: a law and economic analysis of the first five years

Efforts to reform the international financial architecture towards a regime in which sovereign debt restructurings can be managed in a more ‘orderly’ fashion date back to at least the early 1920s. In very stark terms, two possible models have been proposed: a statutory regime akin to bankruptcy procedures for individuals or companies at the national level, or contractual provisions in the underlying bond contracts that clarify the procedure of a potential workout following a default. Concrete policy efforts in recent decades have predominantly focused on the latter model.

The contractual provision that has proven to be most appealing to policymakers and issuers are so-called collective action clauses (CACs). These have become increasingly prevalent since at least the early 2000s. CACs mandate that if a debt restructuring offer is supported by a supermajority of creditors, it becomes binding on all investors, irrespective of their individual preferences. The goal of these provisions is to ex-ante prevent individual creditors from free-riding on the debt relief granted by others and to ex-post remove the risk of protracted holdout litigation in court.

In the wake of the euro area sovereign debt crisis, as part of the broader decision to establish the European Stability Mechanism (ESM) as a lender of last resort to Member States, governments decided to include CACs in domestic-law euro area government bonds. While CACs had become standard clauses in bond indebtedness governed by New York or English law, they were typically not incorporated into securities governed by the issuers’ own laws, ie, domestic-law bonds. Thus, given that the issuer may, at least in theory, retroactively change or remove the CAC by amending its domestic law, their legal value has been contentious from the get-go. As aptly stated in a recent post by Gulati and Weidemaier, ‘the crucial question [still] is whether CAC and no-CAC bonds differ in terms of the protection they offer investors against changes to local law.’

In our new paper, we review the first five years of the European experience with CACs, focusing on both the legal and the economic dimensions.

First, we present a chronology of the most important legal developments, from the legislation incorporating CACs in contracts to landmark lawsuits that have challenged their viability in the context of the Greek government debt restructuring of 2012. In Greece, a statutory CAC was used to bring about the debt restructuring. While courts across various jurisdictions vindicated the use of CACs as a means to implement a sovereign debt workout, they arguably narrowed the scope for retroactively implementing CACs by changing national law. Given the residual legal uncertainties surrounding retroactive legislative amendments of sovereign bond contracts, we contend that the ex-ante clarification of sovereign debt restructuring processes in the euro area was both sensible and warranted.

Second, we complement the assessment of the pertinent legal developments with an empirical analysis of the effects of CACs on financial market prices. More specifically, we identify eleven separate events related to CACs in the euro area, including political announcements and court judgements. Applying econometric methods, we measure the impact of each event on financial market variables, such as government bond yields. The results suggest that their introduction, as well as the key legal developments, have had relatively limited effects on sovereign bond markets, both around the time of their announcement and subsequently. We show that the pricing differential with respect to bonds that do not include a CAC provision are very limited and mostly driven over the medium-term by developments in market liquidity. Against this backdrop, we argue that the gradual implementation of the transition towards the new regime, as opposed to retroactive changes to the stock of outstanding debt, has proven to be a successful strategy. Financial markets have largely reacted in a benign way to the introduction of these clauses, as well as to the judgements vindicating their use in the Greek debt restructuring.

Overall, the European experience with CACs has been a positive one, though a decisive litmus test has, fortunately, not taken place so far. While scope for improvement remains, sensible and timely communication and careful legal drafting have ensured the smooth transition towards a regime to deal in a more orderly fashion with solvency crises in the euro area. Efforts for further contractual reforms aimed at reducing uncertainty about the parameters under which sovereign debt crisis will be worked out should heed these lessons. The results of the Euro Summit of December 2018 suggest they do. Euro area finance ministers intend to introduce single-limb CACs in euro area government bonds from 2022 onwards, thereby further reducing the threat of holdout creditors in future debt workouts.

Sebastian Grund is a Policy Expert at the European Central Bank.

The views expressed in this paper are those of the author and must not be attributed to the European Central Bank.