I. Introduction

1. In its recent Communiqué, the International Financial and Monetary Committee (IMFC) welcomed the inclusion by an increasing number of countries of collective action clauses (CACs) in their international sovereign bonds and the convergence toward a market standard.¹ It called on the Fund to continue to promote progress in this area, and encouraged sovereign debtors and private creditors to continue their work on a voluntary Code of Conduct. The IMFC looked forward to reviewing further work on issues of general relevance to the orderly resolution of financial crises, and called on the Fund to continue reviewing the implementation of its lending into arrears (LIA) policy.

2. Against this background, this report focuses on crisis resolution initiatives under the existing legal framework. Section II describes progress in the use and design of CACs and efforts being undertaken by the Fund and others to encourage the use of CACs in international sovereign bonds.² Section III reports on recent efforts by sovereign debtors and their creditors to develop a voluntary Code of Conduct (the "Code") applicable to both. Section IV reviews the application of the Fund's LIA policy in some recent cases. Section V provides an update of progress in the Paris Club's Evian Approach. Section VI presents a brief update of issues relating to litigation against sovereign debtors, and Section VII concludes.

II. Collective Action Clauses

A. Developments in Market Practice

3. Since March 2004, when the last progress report was finalized, sovereign issues containing CACs increased. They currently represent more than 90 percent of total value of bonds issued since that date, and 41 percent of the value of the outstanding stock of bonds from emerging market countries as of September 23, 2004 (Tables 1 and 2). This largely reflects the increasing number of sovereign bonds issued under New York law that contain CACs, including a large exchange offer by Mexico in April 2004, which replaced several outstanding series without CACs with new bonds containing such provisions.

4. Since March 2004, several emerging and mature market countries have continued to include CACs in their international sovereign bonds.

• Ten emerging market countries, Brazil, Colombia, Korea, Lebanon³, Mexico, Peru, The Philippines, South Africa, Turkey and Uruguay included CACs in their bonds issued under New York law. Among mature market countries, only Italy issued under New York law and continued to include CACs in such issues. In contrast, Jamaica did not include CACs in its New York law issues, largely because this was a reopening of an old issue launched in 2002.⁴
  
  
• Several issues under English and Japanese law included CACs, as is the market practice in those jurisdictions. Brazil, Croatia, Cyprus, the Czech Republic, Hungary, the Slovak Republic, The Philippines, Thailand, Turkey and Ukraine are among the emerging market countries, and Austria, Greece, New Zealand and Sweden among mature market countries that issued under English law. Hungary and Poland both issued under Japanese law.
  
  
• Jamaica made the only issuance under German law. This bond did not include CACs. This is in line with the practice under German law bond issuances, pending ongoing legislative clarification on the effectiveness of CACs in that jurisdiction.⁵

5. Market acceptance of CACs has continued with no observable impact on pricing even after international liquidity conditions toward emerging market debt gradually tightened in the second quarter of 2004. As has been the case during the past year, market reports on new sovereign bond issues are not focusing on the inclusion of CACs in bonds issued under New York law, reflecting the broad acceptance of CACs as market practice.

B. Design of CACs in Recent Issues

6. Since mid-2002, the Executive Board has repeatedly encouraged the inclusion of CACs in international sovereign bonds and, in particular, in those governed by New York law. While recognizing that any decision concerning the design of CACs will ultimately be made by the issuer and its creditors, Directors considered it appropriate to continue existing practice in the London market and encouraged the use in New York law bonds of CACs that are broadly in line with the provisions recommended by the G-10 Working Group.⁶ They recognized, however, that it was too early to reach a definitive view on the degree of standardization in terms of the design of CACs within and across jurisdictions. Table 3 contains a summary of the CACs contained in New York law bonds issued since March 2004 and a comparison of these provisions with the G-10 recommendations.⁷

• Regarding majority restructuring provisions, all recent New York law bonds utilized a 75 percent voting threshold.⁸ After a relatively brief period of uncertainty regarding the degree of standardization between investment and non-investment grade countries, it now appears that market practice for bonds issued under New York law has rapidly converged to a 75 percent voting threshold (based on outstanding principal) for majority restructuring provisions, in line with the G-10 recommendations. In particular, Brazil lowered the voting threshold in its recent sovereign issues to 75 percent from 85 percent, reflecting the practice followed by a number of non-investment grade countries. Almost all of these bond issues contain an expanded disenfranchisement provision that excludes bonds that are held by public sector instrumentalities, in addition to those held by the sovereign issuer, for quorum and voting purposes, which is consistent with the G-10 recommendations.
  
  
• With respect to majority enforcement provisions, all recent bond issues governed by New York law, except those of Lebanon, adopted a 25 percent threshold for acceleration.⁹ They differ, however, on the threshold for de-acceleration. While the bond issuances of Brazil, Italy, and Turkey included a 66⅔ percent threshold for de-acceleration, the others relied upon a threshold of more than 50 percent of outstanding principal. The Lebanon bonds do not contain any majority enforcement provisions. Finally, all the recent New York law bond issues utilized a fiscal agency structure.¹⁰
  
  
• Continuing its practice since the debt restructuring in May 2003, Uruguay's recent bond included a limited form of aggregation provision which gives Uruguay the option to amend payment terms on the basis of aggregate voting across affected bond series issued under the same trust instrument.¹¹ It also contains a transparency provision which requires Uruguay to provide certain types of information to investors before any future modification of the bonds is sought.
  
  
• The English law bonds recently issued by Latvia contain an engagement clause that allows the bondholders with at least 50 percent of outstanding principal to appoint any person or a committee to represent their interests in the event of a default or if a restructuring is publicly announced, provided that no appointment would become effective over the objection of the holders of more than 25 percent of outstanding principal.¹² This clause is consistent with the G-10 recommendations.

C. Encouraging the Use of CACs

7. Staff has continued to take a proactive role in promoting the inclusion of CACs in international sovereign bonds encouraging their adoption both in the context of the use of Fund resources and Article IV consultation discussions. Staff continues to maintain an active dialogue with private market participants and debt managers from a number of emerging market countries to further discuss the design of CACs and promote their use, including through the Forum for Public Debt Managers.

8. The G-10 Deputies Group has continued its efforts to promote and monitor developments in the use of CACs. Most recently, the Group discussed a report prepared by the Bank of England reviewing the progress that has been made in introducing CACs in international sovereign bonds and the scope for further engagement with issuers and market participants.¹³ The G-10 Deputies intend to report on their stocktaking in the meeting of the G-10 Ministers and Governors on October 3. Staff will inform the Executive Board of the deliberations of the G-10 Ministers and Governors on this matter.

Table 3. Collective Action Clauses: G-10 Recommendations and New York Law Governed Bonds Issued Since March 2004
Provisions	G-10 recommendations	Brazil, Colombia, Korea, Italy, Lebanon, Mexico, Peru, Philippines, South Africa, Turkey and Uruguay
Amendment of Key Terms	75 percent based on either outstanding principal or duly convened meeting.	Brazil, Colombia, Korea, Italy, Mexico, Peru, Philippines, South Africa, Turkey and Uruguay: 75 percent based on outstanding principal (including governing law and submission to jurisdiction). Lebanon: 75 percent based on duly convened meeting. Uruguay: option to amend on the basis of aggregate voting across affected bond series issued under the same trust instrument - 85 percent of the aggregate outstanding principal of all issues proposed to be affected and 66⅔ percent of the outstanding principal of each affected series
Disenfranchisement	Bonds owned or controlled directly or indirectly by the issuer or its public sector instrumentalities.	Generally bonds owned directly or indirectly by the issuer or its public sector instrumentalities.
Acceleration	25 percent of outstanding principal.	25 percent based on outstanding principal (except the Lebanon bond, where each bondholder has the right to accelerate upon default).
De-acceleration	Between 50 and 66⅔ percent of outstanding principal.	Colombia, Korea, Mexico, Peru, Philippines, and South Africa: more than 50 percent based on outstanding principal. Brazil, Italy, Turkey and Uruguay: 66⅔ percent. Lebanon: none.
Initiation of Proceedings	Mandate the use of a trust or an equivalent legal structure where the trustee can be instructed by 25 percent to initiate lawsuits. Pro rata distribution of recovered proceeds under trust or equivalent structure.	Any bondholder.
EngagementProvision	A bondholder representative be appointed for the life of the bond. 66⅔ percent to appoint at any time any person to represent all holders in negotiation with the issuer or other creditors.	None.
Information Provision	A covenant requiring the issuer to provide certain types of information over the life of the bond and following an event of default.	Uruguay bond requiring Uruguay to provide certain types of information to investors before any future modification of the bonds is sought..
Documentation	Trust or an equivalent legal structure.	Fiscal agency agreement (except the Uruguay bond which is issued under a trust indenture)

9. The International Primary Market Association (IPMA), a group of market participants, together with six other trade associations, are leading an effort to define a market standard for CACs that reflects current best practice and is mutually acceptable to issuers, investment banks, and investors. Staff will provide the Board with a commentary should such a standard be agreed.

III. Code of Conduct

10. In its recent Communiqué, the IMFC encouraged sovereign debtors and their private creditors to continue their work toward developing a voluntary Code of Conduct. Recent experience in crisis countries suggests that debtor-creditor dialogue is critical to the success of the debt restructuring process. A Code could, in principle, facilitate dialogue between creditors and debtors, promote corrective policy action to reduce the frequency and severity of crises, and improve the prospects for an orderly and expeditious resolution of crises. For this reason and because the effectiveness of voluntary rules of conduct hinges on its acceptability to those most affected, this effort is best led by sovereign debtors and their private creditors. In this context, the experience with the introduction of CACs, which followed the same approach, is encouraging.

11. Building on work undertaken in the spring, efforts to develop a Code are continuing in both the G-20 and the Institute of International Finance (IIF).^14,15 The IIF, with a view to moving the process forward, has continued to develop draft Principles-rather than a detailed Code-predicated on enhanced debtor-creditor cooperation that are based on four pillars-information sharing and transparency, close debtor-creditor dialogue and cooperation, good faith actions during debt restructuring, and fair treatment of all parties (Box 1). Based on recent multi-party discussions, there appears to be an increasing consensus within the investor community and among selected emerging market issuers on the draft Principles. While work continues to fine tune the draft and to widen the spectrum of sovereign issuers involved, the IIF expects to circulate the draft Principles to the G-20 in October 2004 for possible endorsement. Notwithstanding the progress on the draft Principles, challenges still remain in devising a tangible Code that is detailed enough to provide practical guidance, while at the same time being sufficiently flexible to be applied to a diverse set of country circumstances. Staff will continue to monitor progress and will provide the Executive Board with a commentary should the Principles be agreed.

IV. Recent Application of the Lending Into Arrears Policy

12. The core objective of Fund financing-to assist effective balance of payments adjustment, without recourse to measures destructive to national and international prosperity and while safeguarding the Fund's resources-underpins the Fund's LIA policy.

13. Under the LIA policy, the Fund lends into sovereign arrears to private creditors on a case-by-case basis and only where (i) prompt Fund support is considered essential for the successful implementation of the member's adjustment program, and (ii) the member is pursuing appropriate policies and is making a good faith effort to reach a collaborative agreement with its creditors.¹⁶ In 2002, the Board reviewed the application of the good-faith criterion of the LIA policy and added procedural clarity about the nature and modalities of good-faith efforts expected of debtors during the restructuring process in order to reach a collaborative agreement with creditors.¹⁷

14. Financing assurances reviews remain a fundamental requirement of the LIA policy. In particular, after approval of a Fund arrangement involving lending into arrears, financing assurances reviews are required for each purchase until outstanding debt arrears to private creditors have been "cleared" (e.g., through a rescheduling agreement or actual payment). These reviews allow the Board to assess whether developments in creditor-debtor relations have not undermined program implementation and, more specifically, that the member's capacity to repay the Fund has remained intact. The policy applies to all Fund arrangements.¹⁸

15. When first formulated in the context of the Brady initiative in 1989, the LIA policy was designed to facilitate the approval of a Fund arrangement before foreign commercial banks had provided assurances regarding their willingness to support a restructuring consistent with the assumptions of the program.¹⁹ Since its inception, the policy has evolved with changes in the financial environment of sovereign debtors and their creditors. Most significantly, in 1999, the scope of the policy was broadened to encompass sovereign debt to all private creditors, including holders of international sovereign bonds, recognizing that bonded debt raised particular challenges for restructuring and the provision of Fund financing in that context.²⁰ This section identifies the cases where the LIA policy has been applied in Fund-supported programs over the past two years involving sovereign arrears to private creditors, including in the context of a sovereign debt restructuring.²¹

GRA cases

• Argentina-the current and the previous stand-by arrangements have applied the Fund's LIA policy. The number of outstanding debt instruments, the diversity of the private creditor base to which arrears have been incurred (including foreign, domestic, institutional and retail bondholders), and the total size of arrears have contributed to the complexity of the case. The Global Committee of Argentine Bondholders (GCAB) has been recognized by the Argentine authorities and the Fund as a representative creditor group with whom good-faith negotiations should be conducted. Purchases under these stand-by arrangements have been, or are, subject to financing assurances reviews. The letters of intent for these arrangements have included explicit steps the government would undertake to meet the "good faith" criterion under the LIA policy.
  
  
• Serbia and Montenegro-the current extended arrangement was approved in the context of arrears to foreign commercial bank creditors. The negotiations between Serbia and Montenegro and the commercial banks have been conducted through the London Club. Financing assurance reviews have been completed in light of progress in these negotiations. Negotiations were protracted, inter alia, by the need to achieve comparability of treatment with Paris Club terms, but were successfully concluded in July 2004.
  
  
• Gabon-arrears to external private creditors existed when the Board approved the current stand-by arrangement. The authorities committed to seek a rescheduling with private creditors-on terms comparable with the rescheduling from official bilateral creditors-in order to fill the financing gap. A review of financing assurances will be conducted in conjunction with the first program review, currently scheduled for September 27.

Non-HIPC PRGF cases

16. In the context of PRGF arrangements for non-HIPCs, the LIA policy was applied in only two cases.

• Albania-the PRGF-supported program recognized the need to regularize long-standing arrears to external private creditors, but progress has been complicated by problems of debt reconciliation. Financing assurance reviews have been completed on this basis.
  
  
• Dominica-the current PRGF arrangement was approved while arrears to external private creditors were outstanding. A financing assurances review was completed at the time of the first program review against a backdrop of negotiations for a comprehensive debt restructuring. At the time of the second program review, the LIA policy did not apply as the relevant arrears to private creditors had been eliminated.

HIPC PRGF cases

17. The application of the LIA policy appears to have been less rigorous in the context of PRGF arrangements for HIPC cases.²² The objective of achieving broad participation in the HIPC Initiative has led to programs designed on the assumption that private creditors will provide the full debt relief envisioned in the HIPC Initiative. However, PRGF arrangements for HIPC countries have generally not included explicit financing assurances reviews requiring an assessment that the member was making a good faith effort to reach a collaborative agreement with its private creditors.²³

• Nicaragua is one HIPC country where the PRGF arrangement has involved an explicit application of the LIA policy. Nicaragua's PRGF-supported program has been implemented in the context of arrears to commercial creditors whose original claims were not tendered in a 1995 IDA-sponsored buyback. Litigation by one of these commercial creditors led to an initial Belgian court order restricting payments by Nicaragua through Euroclear to holders of "indemnity bonds" and thus resulted in Nicaragua incurring arrears at the end of 2003 on these bonds.²⁴ Nicaragua's negotiation with commercial creditors have been framed by seeking agreement comparable to Paris Club and HIPC terms and the "good-faith" criterion has been judged in that context. Until the clearance of the arrears (which occurred once the court order restricting payment to the indemnity bondholders had been removed), Nicaragua established a good faith posture with respect to the indemnity bondholders by placing payments amounts in an escrow account.

V. Update on The Evian Approach

18. The Evian Approach-a new, flexible, approach adopted by the Paris Club for addressing debt sustainability concerns of non-HIPC countries-is continuing to evolve.²⁵ To date, however, experience with the Evian Approach has been limited.

• Since March 2004, the Paris Club has provided flow reschedulings to the Dominican Republic, Gabon, and Georgia under the Evian approach after considering the issue of debt sustainability on the basis of staff projections and analysis of their balance of payments. The agreed minutes for the latter two include goodwill clauses indicating that the Paris Club would consider further treatment of maturities, with the clause for Georgia specifically noting that the Club would be ready to examine the country's debt situation under the Evian Approach at the end of the program period.
  
  
• In the context of existing procedures to secure financing assurances from official bilateral creditors, Fund staff has provided-consistent with the Evian approach in cases where solvency has been identified as an issue-balance of payments projections, including debt sustainability analyses, for Argentina and Iraq to Paris Club creditors. These projections have included various debt reduction scenarios based on assumptions provided by the Club. The Paris Club has not yet come to a view on whether Argentina will benefit from debt reduction by the Club. No agreement on debt reduction for Iraq has been reached by the Club as yet.

19. Staff will continue to update the Board on developments in the Evian Approach.

VI. Update on Sovereign Debt Litigation by Private Creditors

20. As recently noted, sovereign debt litigation continues to pose some challenges to the orderly resolution of sovereign debt crises.²⁶ Among the interesting developments in this area are:

• LNC's appeal against the decision of the Brussels Court of Appeal in the LNC vs. Nicaragua case which rejected the claim that the contractual pari passu clause provided a legal basis to interrupt payments between a sovereign debtor and its other creditors.
  
  
• Although enforcement proceedings against Argentina have diminished, additional class actions have been filed raising novel and potentially far-reaching legal arguments.

Continuing litigation over pari passu clause

21. LNC's appeal to the Belgian Supreme Court (Cour de Cassation) in the LNC v. Nicaragua case attempts to reopen the argument that the pari passu clause provides a creditor with a right to proportionate payment.²⁷ This appeal focuses on the narrow ground of the Brussels Court of Appeal's ruling that, irrespective of the construction of the contractual pari passu clause, such clause could not be invoked against Euroclear, the settlement agent under the Nicaragua's indemnity bonds, since Euroclear was not a party to the contract in which the pari passu clause arose. LNC argues that this conclusion was erroneous as a matter of Belgian law. Consequently, LNC seeks to preserve the ruling in the Elliott/Peru case that accorded the judgment creditor with the right to interrupt payments made in apparent violation of the pari passu clause. The Belgian Supreme Court is expected to rule on LNC's appeal within the next year.

22. The revival of the LNC vs. Nicaragua case indicates that the legal effect of the pari passu clause has not yet been definitively settled in the Belgian courts (nor New York courts).²⁸ Meanwhile, the legislative process is continuing in Belgium to adopt a law that would prevent a judgment creditor from obtaining a court order that would preclude Euroclear from channeling payments from a sovereign debtor to its bondholders. The draft law has already been approved in the legislative Chamber and is now in the final process of formal adoption.

Developments in litigation against Argentina

23. The lull in enforcement activity by judgment creditors against Argentina is notable. Judgment creditors may feel somewhat frustrated by the inability to find assets available for attachment. In the New York proceedings, the extensive time spent contesting the scope of information that Argentina should provide on the location of its commercial assets, yielded rather limited information to the judgment creditors. However, it remains to be seen whether the judgment creditors will re-embark on aggressive enforcement proceedings.

24. Notwithstanding the apparent difficulty in enforcing court judgments against Argentina, five additional class actions have been filed in New York court since February, 2004, bringing the pending class actions to fifteen. Only one class action has been certified to date (a procedural step necessary for continuation of the actions) and that action appears to have been stalled by the ruling that bondholders would need to affirmatively opt-in the litigation in order to recover in the class action.

25. However, one of the recently filed class actions, the so-called "Lavaggi class action", raises some novel legal issues.²⁹ In addition to the standard breach of contract claim for non-payment of principal and interest on the bonds, the class action seeks redress for (i) breach of duty of good faith and fair dealing and (ii) unjust enrichment (alleged on the basis that Argentina used the funds available in payment under the bonds "for its own purposes"). Based upon these allegations, the class action seeks punitive damages in excess of US$100 billion from Argentina. A claim for punitive damages in relation to a sovereign debt default is novel and is yet another example of aggressive strategies intended to raise the stakes in sovereign debt litigation.

VII. Conclusions

26. The trend toward the use of CACs in international sovereign bonds issued under New York law has gained momentum. Market acceptance of CACs has continued, with sovereign issues containing CACs growing to represent more than 90 percent of total value of bonds issued. Staff continues to maintain an active dialogue with private market participants and debt managers from a number of emerging market countries to promote the use of CACs. Building on work undertaken in the spring, efforts to develop a Code are continuing in both the G-20 and the Institute of International Finance (IIF). While challenges remain in devising a detailed and tangible Code, the draft general Principles formulated by the IIF could form a basis for further discussions in the G-20 and the wider investor community, and a broad agreement on the Principles could be reached later in the year. As requested by the IMFC, the implementation of the Fund's lending into arrears policy will continue to be reviewed. The Evian Approach-a new, flexible, approach adopted by the Paris Club for addressing debt sustainability concerns in non-HIPC countries-continues to evolve, but experience, to date, with the approach has been limited.