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5 Int'l Fin. L. Rev. 10 (1986)
Converting Sovereign Debt into Equity Investments

handle is hein.journals/intfinr5 and id is 394 raw text is: 10 Any financial transaction in which each party at the closing wears an equally smug expression tends to arouse suspicion. But consider the following. A multinational company wants to capitalise its subsidiary located in a country that is undergoing a general external debt restructuring. The subsidiary cannot afford to borrow from local banks because the national debt crisis has forced the debtor government to finance its own deficit from local capital markets and this has pushed domestic interest rates to a prohibitively high level. A commercial bank with a loan outstanding in the country would like to liquidate its loan portfolio in that country in the face of repeated reschedulings, new money requests and eroding margins. In order to avoid this gloomy prospect, the bank is prepared to sell the asset at a significant discount. For its part, the country wants to revitalise its economy through increased foreign investment and reduce its external debt service burdens. Universal happiness One solution is for the company to buy the bank's assets at a discount, convert the loan into its local currency equivalent and invest the local currency pro- ceeds in the subsidiary. In this way the company will have obtained the local currency necessary to capitalise its subsidiary at a highly favourable rate (reflecting the discount it received when it purchased the loan from the bank). The subsidiary will have received an infusion of new capital without resorting to local borrowing. The bank will have shed its troublesome loan and, depending on the discount used to compute the selling price of the loan compared to the bank's previous writedown of the asset, the bank may even wind up booking a profit on the sale. The country will have: reduced its aggregate stock of external debt; encouraged foreign investment in a dome- stic industry; and removed a potentially cantankerous lender from its creditor group. If debt/equity conversion transactions of this kind can bring universal happiness to the player caught in a sove- reign debt restructuring, why aren't they much more common? Before tackling this question, it is important to dis- tinguish between debt/equity conversion programmes and 'relending' or 'on-lending' schemes. In a relending transaction the lender withdraws a credit covered by a public sector restructuring agreement and relends the local currency equivalent of the amount withdrawn to another borrower (usually a private sector borrower) in the debtor country. An on-lending transaction is similar but usually involves credits that have been extended to the debtor government in the form of 'new money' loans and which are then on-lent to specified public or private sector borrowers in the country. Relending or on-lending schemes play a role in the sovereign debt restructurings being implemented by Argentina, Brazil, Chile, Mexico, the Philippines and several others. Debt/equity conversion programmes that are expressly contemplated by sovereign debt restructuring agreements with commercial banks may be forced to operate within constraints imposed by those agreements. The con- straints are designed to ensure equal treatment among creditors: the capital portion of investments made with the proceeds of the restructured external debt may not be repaid to the investor earlier than the scheduled amortisa- tion of principal on the restructured debt; and the pay- ment of dividends for these investments may be similarly restricted. These restrictions are intended to prevent the debtor country using the mechanism of a debt/equity conversion to effect a preferential payment (in foreign exchange) to a specific creditor. They are not generally objectionable to the debtor country as they coincide with the government's own desire to manage the outflow of foreign exchange. The redemption of an item of restructured debt by an obligor may raise questions under 'mandatory prepay- ment' clauses in the restructuring agreements signed by that obligor, or other public sector obligors in the same country. These clauses often require each public sector obligor to prepay all lenders on a rateable basis if any obligor prepays any credit covered by a public sector restructuring agreement (and sometimes other categories of public sector external debt). So the redemption of a specific credit covered by one of these agreements, even if effected in local currency, may constitute a prepayment of that credit which requires rateable repayment of all other credits under that agreement and possibly every other public sector restructuring agreement. However, in the legal documentation implementing the restructuring process for some countries, these mandatory prepayment clauses have been carefully drafted to specify that only prepayments effected in foreign currency will trigger the clause. Under this drafting, the redemption of a credit for local currency should cause no mandatory prepayment difficulties. Foreign investment restrictions A major constraint on these programmes may be the foreign investment restrictions in the debtor country, which may regulate the percentage of foreign ownership of local companies, prohibit investment in certain indus- tries, or impose other restrictions. Increasing pressure is being applied (by the US government, the International Monetary Fund and the World Bank, among others) to liberalise foreign investment restrictions. But in some countries debt/equity conversion programmes can be severely constrained. International Financial Law Review September 1986 Converting sovereign debt into equity investments Transforming sovereign loans into equity investments in enterprises located in the debtor country can be beneficial for the investor, the commercial bank holder of the debt and the debtor country. By Lee C Buchheit of Cleary, Gottlieb, Steen & Hamilton, New York

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