Would Collective Action Clauses Raise Borrowing Costs?

Collective action clauses in bond contracts tend to reduce the cost of borrowing for more creditworthy issuers. This unexpected conclusion emerges from a paper by Barry Eichengreen of the University of California at Berkeley and Ashoka Mody of the World Bank published by the Centre for Economic Policy Research. The two economists say that there is evidence, however, that less creditworthy borrowers face higher spreads. The authors believe that those who enjoy a rating of above 50 on the Institutional Investor scale benefit because of advantages of provisions facilitating an orderly restructuring.

The research compared the spreads on bonds subject to British law, which typically include collective action clauses, and those under US law, which do not. (Allowances were made for the different sorts of borrowers operating under the two regimes and for the currency vehicle.) British law provides for holders of debt securities to call a bondholder assembly with the power to appoint a representative to negotiate with the debtor. There is provision for majority voting with a resolution binding on all bondholders, providing the required majority has agreed.

The results are important because of the now widespread agreement that the IMF should no longer provide large-scale financial assistance to prop up shaky currency pegs and bail out private investors. The problem is that any IMF commitment to stand back and let events run their course will not be credible so long as there does not exist a mechanism for debtors and creditors to collectively resolve their differences; this is what collective action clauses are supposed to provide.

But there have been objections from many emerging markets where it has been argued that ‘bailing in’ and collective action clauses would increase borrowing costs. This study provides at the very least a partial refutation of those arguments. Furthermore, the authors argue, the improvement in the standing of many emerging market borrowers should increase the attraction of collective action clauses.

The authors compare such provisions with bankruptcy rules: ‘Few market participants would argue for the abolition of bankruptcy rules and the reinstatement of the debtor’s prison to discourage borrowers from walking away from their debts...’.

Collective action clauses remain under active consideration in various international fora. In recent days the UK has attempted to lead by example, by for the first time including a collective action clause in a newly issued euro-denominated bond.

The authors conclude that the results of their research ‘do not support the dire consequences predicted by some market participants of including collective action clauses in loan contracts’. If reform of the global financial architecture is to strengthen market discipline ‘by encouraging investors to more generously reward more creditworthy borrowers and penalise less creditworthy ones, then more widespread adoption of collective action clauses, which would reduce borrowing costs for the more creditworthy while raising them for their less creditworthy counterparts, would seem to be a step in the right direction.’

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The Authors:

Barry Eichengreen is a Professor of Economics at University of California at Berkeley and a Research Fellow in CEPR’s International Macroeconomics and International Trade research programmes. Ashoka Mody is at the World Bank.