Lebanon Ad Hoc Group Cautions Against Giving Large Depositors Preferential Treatment, Urges Authorities to Engage Early to End Five Years of Delay and Inaction

The ad hoc group, or AHG, of international Lebanon bondholders supports the government’s pledge to protect small deposit accounts in the coming clean-up of the nation’s crisis-ridden financial sector, the restructuring advisors to the bondholders told Octus, formerly Reorg.

However, the AHG will oppose any preferential treatment offered to large depositors or shareholders of Lebanon’s insolvent banks to the detriment of bondholders.

Billions of dollars of deposits have been frozen in Lebanese bank accounts since the country sank into economic and financial distress in 2019, leaving depositors unable to withdraw more than a few hundred dollars per month. The Lebanese central bank reports deposit liabilities to the financial sector of 7.6 quadrillion Lebanese pounds ($85 billion at LBP 89,500/$1) and LBP 629 trillion ($7.02 billion) of public sector deposits.

“The bondholder group absolutely recognizes that the brunt of the crisis has been borne by the population in general. In particular, the part of the population that had nowhere else to go but to put their savings into the banks, has to be protected. How it is protected is another matter, but the general principle makes sense,” says David-Alexandre Gadmer, head of Sovereign Advisory and managing director in Houlihan Lokey’s Financial Restructuring Group. “We in the group draw attention to the large deposit accounts that yielded very high rates in a global low-rate environment. Investors in these large deposit accounts took comparable market risk to that undertaken by eurobond investors. As such, it is very important that the two categories of claims receive commensurate treatment.”

“The small deposits were event-takers. They had nothing to do with the crisis. That category should be treated as favourably as possible. If we can have them recover 100% in some shape or form, they should have priority over investors choosing to take risks.”

Gadmer says international bondholders realize substantial upfront debt relief efforts to help rebalance Lebanon’s books will potentially be needed, but stressed that large depositors must be expected to make similar concessions.

White & Case and Houlihan Lokey are acting for the Lebanon ad hoc group, whose steering committee has grown to 11 members while an “outer SteerCo” counts between 15-20 firms and is growing. The steering committee includes Aberdeen Investments, Amundi, BlackRock, RBC BlueBay, GMO, Greylock Capital, Mangart Capital, Mesarete Capital and Morgan Stanley Investment Management. Lazard and Cleary Gottlieb are advising Lebanon.

The investors in the SteerCo range from real money institutions to distressed debt hedge funds and see a unique but narrow window of opportunity for the authorities to bring Lebanon’s economy back on track. This would also allow the government to restructure the eurobond claim, which is approaching $50 billion when including over five years of accrued and unpaid interest since the 2020 default. The bonds are quoted at 17 cents, according to Solve. In January, Lebanon’s Council of Ministers extended the statute of limitations period under the bonds by three years to March 2028.

“This is a systemwide crisis that calls for comprehensive and sustainable solutions and our group supports the government’s reform path. We see our position as wide support coupled with some pressure to ensure we do not relapse into the situation of paralysis we have seen in the past years,” says Gadmer.

The advisor cautioned the Lebanese side against thinking of the international investors as residual claimants in a multifactor financial equation in which they are assumed to bear the losses required to reach the IMF-mandated metrics. “The bonds are not the plug in the system that can be used to balance things out. Principles of fairness and comparability of treatment are very important here and things must happen concurrently rather than sequentially. We want to be constructive and part of a solution, but a plan should not be forced upon us,” explains Gadmer.

Salil Shah, managing director at Houlihan Lokey, further emphasizes that given the size of the eurobond holdings and the need to secure high consent levels across numerous series of bonds, it is critical for the authorities and banking sector participants to engage constructively and on a real-time basis with the SteerCo and its advisors. This will ensure that all parties are working toward a collective deal capable of securing requisite consents to be implemented, he says. “If the components of a deal do not work for us, they are not going to work for the international community that the authorities need to win over,” stresses Shah.

Ian Clark, partner and global head of the Sovereigns at White & Case, says the bondholders have requested that the authorities and the IMF be transparent and open with the bondholders from the start. “We’re not going to be patient if we get to a point later on where we are presented with a fait accompli,” Clark notes. The advisors note they have so far seen good intentions from the authorities and the IMF to engage.

Gadmer sees certain critical geopolitical elements aligning for Lebanon at the moment and believes that now is the time to find long-lasting, credible solutions. Although Israel continues to bomb sites in Lebanon, the bondholders’ advisors believe investors will be pragmatic when assessing the conflict risk. “While it will be up to individual bondholders to decide, I would observe that Ukraine just restructured its debt in the middle of a hot war. I wouldn’t say there is more uncertainty in Lebanon than in Ukraine. It’s different and it’s challenging but I would not consider geopolitical complexity a bar to a deal that creditors can support,” says Clark of White & Case, adding that several regional governments have a long tradition of supporting stability in Lebanon.

A Five-Year Wait

The bondholders first organized with White & Case in early 2020 around the time of the sovereign default, but debt restructuring talks never took off because the government at the time failed to show willingness to implement difficult-but-needed reforms.

“It was a very difficult situation. The default itself was chaotic, created largely by the black hole in the banking sector and the unraveling of the financial engineering at the central bank,” says Clark, adding that the group then opted for “strategic patience.”

“Early on, the original SteerCo decided not to exercise its legal rights. We obviously looked at what would be needed to enforce under individual series of bonds for missed payments of principal or interest, or to accelerate. We thought about different strategies, but ultimately the group was very focused on finding a consensual solution. The feeling was that going aggressive that early in the process and without any meaningful interaction with the authorities would be giving up leverage, and the standpoint was to adopt “strategic patience” and let the chaos in Lebanon play itself out. Without good data and without an IMF program framework, there was a feeling that the restructuring process wasn’t going anywhere, and premature legal action by bondholders could potentially be manipulated to the political advantage of the authorities,” Clark notes.

Last year’s weakening of the Iran-backed militant group Hezbollah and the successful election of a president and a new prime minister brought momentum back to Lebanon. Prime Minister Nawaf Salam signaled clearly that reforms are urgent and at the top of his agenda and the eurobonds soared in price from 6 to 19 cents.

The AHG has now established “engagement with the IMF which is more meaningful than the time when the staff-level agreement was being discussed two years ago for political purposes,” observes Gadmer. The investors see 2025 as the year when Lebanon’s long-standing default could be resolved and they stand ready to engage with all stakeholders, but the window of opportunity will not remain open for long.

Missing Macro Data

Lebanon’s half-decade in deep distress has plunged the economy into an information void and validated macroeconomic indicators are hard to come by. Lebanon’s imploding exchange rate (down 97% since 2019), a large cash economy and institutional breakdown have created a situation where investors and policymakers don’t actually know what Lebanon’s GDP has been in the past years.

“This is one of the very important peculiarities of this case,” says Gadmer. “Normally, the IMF has 50+ years of reliable data and insights from Article IV consultations, but in this case, we are dealing with a situation where financial sector data was, at best, inadequately reported for years – within a multi-crisis, war-torn, and unstable economy where producing reliable macroeconomic data is extremely challenging. Even the authorities are having difficulties producing macro-fiscal data, such as a GDP number. The IMF is doing its work and the technical workstream is an ongoing process.”

Reforms and Impact on Stakeholders

Although Lebanon’s deep reform program is expected to be negotiated and executed in parallel with the debt restructuring, the creditors stress that Lebanon’s financial sector loss allocation bill, known locally as the “Financial Gap Law,” is an immediate priority that must be dealt with first.

“Lebanon will benefit from having a rightly-sized and well-functioning banking sector. The idea is not to wipe the banks away, but to restructure so that the banking sector can carry the economic recovery and reconstruction. This is essential. We saw some progress in May with the Bank Secrecy Bill and the banking resolution framework is on the way, but the really big piece is how do you deal with the financial sector losses,” according to Gadmer. Lebanon’s bank services represented a significant share of the economy before the 2019 crash.

“In the systemwide crisis that we are talking about here, people should obviously look at the role of the authorities’ unsustainable policies in the last three decades, but it’s not going to yield anything if losses are allocated in terms of who is responsible for what. It has to make sense, be fair and respect international restructuring standards and principles. That’s why the idea that the state should take on the full burden is nonsensical. First, the state simply doesn’t have the capacity to do so. Then, it would also be unfair to bail out some people while letting the entire population bear the cost and burdening the economic recovery of the country,” Gadmer notes.

“If you put more pressure on the state, it means less public services and probably higher tax pressure on the population, which has already faced a lot of hardship in the past five years. This is why we think it would be unfair to put more pressure on the state even if we consider that some of the past governments were, at least partly, at fault for the policies that led to where Lebanon is today. This is a new government and it should serve the generations to come,” adds Paul Zein, vice president at Houlihan Lokey’s sovereign advisory practice.

According to White & Case Partner Brian Pfeiffer, the lawmakers in Beirut are now faced with a crucial zero-sum game. “There’s a limited pie to share and if you go too far in benefitting one party, you’re not going to be able to put a deal together. For the Lebanese government, this is their opportunity, but they have to be judicious about what they do with their limited pool of resources, because there is just not enough to go around. If you give one segment too much, that’s going to put pressure on another portion.”

“There will be a bank-by-bank audit and not all banks are in the same situation,” Gadmer says. “When you look at any banking sector you want it to be built around banks that are solid and well capitalized and able to perform their key function: lending to the economy. By no means do the bondholders seek to dictate how the financial sector restructuring should be done. But we want the central bank and the government to recognize that the outcome of that action has a big impact on the final outcome of the broader recovery story.”

The Association of Banks in Lebanon, or ABL, has repeatedly argued that the nation’s commercial banks should not be held accountable for “the sovereign decisions they have adhered to” during and since the Lebanese financial crisis.

Complex Bondholder Landscape

The AHG has not yet declared how much principal its members hold, nor if it has a blocking minority stake in each of the 29 bonds, which do not feature aggregated collective action clauses.

As a result of Lebanon’s era of large-scale financial engineering, substantial amounts of eurobonds sit on the balance sheets of the Banque du Liban, or BdL, and the country’s commercial banks. On top of that, a sizable amount is believed to be in the hands of retail investors and private Middle East investors. The central bank disclosed on May 31 that its eurobond position has a market value of $914 million, which would imply a nominal holding north of $5 billion if the current market price of 17 cents is applied.

Clark expects the central bank’s holdings will be disenfranchised when it eventually comes to voting on a restructuring plan, but the picture is less clear when it comes to the banks.

“When the domestic banking system itself has huge problems and will need to be restructured and recapitalized, the behavior of local banks as bondholders is unpredictable,” Clark says, adding that the dynamic between the ad hoc group and the local banks will be particularly important because of the need to secure 75% support for the restructuring in each of the series of eurobonds.

Asked what happens to the eurobonds held by a nationalized bank, Clark says the situation “becomes more fact specific. If you had banks which are put into some sort of administration or some sort of government oversight, the question is who has control over decision-making and is it being exercised on behalf of the state. If they were somehow indirectly under the influence of the BdL or the Ministry of Finance, then they would likely be disenfranchised.” A number of the Lebanese banks are working with DLA Piper, and White & Case is in touch with their legal advisor.

Lebanon also faces a more traditional sovereign restructuring challenge. “With the disaggregated and diffuse structure of the bondholder community, and absence of aggregated collective action clauses, there is a very high opportunity at a relatively low cost for holdout behavior,” says Clark. “Unless the authorities can convince a strong committee like ours and we can in turn convince the market that what is offered is fundamentally a fair deal, there is a very real possibility that we will get to the execution stage and be unable to deliver a deal. Trying to treat other stakeholders preferentially at the cost of bondholders will be a wasted opportunity because we will only get one shot at this. If the authorities get the balance wrong, they may find themselves with a truly intractable problem for years.”

The advisors underscore that it could become a concern for the AHG if other investors take an aggressive stance to sue the government for a higher recovery. “We’ve had that problem in a number of other situations. The key point for the authorities to understand to minimize this risk is that if they can get a deal with the committee, the committee can help them get enough support across the board,” says Pfeiffer of White & Case. “We’re focused on supporting a constructive process which doesn’t spiral out of control.”

SCDI Libanais?

Lebanon’s uniquely distressed state and uncertainty around basic macroeconomic data have led many market participants to point to a state-contingent debt instrument, or SCDI, as a potential solution for the notes. However, Clark says investors’ general preference is for the core recovery instrument to be in the form of plain vanilla bonds. “They trade well, they are predictable. That’s the best outcome for the majority of holders. The more complex the instrument gets, there will be concerns about if it will trade well, how it will be rated, how it will be viewed by the IMF under the debt sustainability analysis. The SCDI is not the preferred way, it’s a solution that typically emerges from an IMF program and a market perception that the program’s baseline projections may be overly conservative or not adequately reflect upside factors. So, we’re going to have to see what comes out of the dialogue with the IMF. Based on that we’ll see if we need to think of some sort of SCDI or maybe even a true value recovery instrument as part of the recovery package.”

Gadmer adds that Lebanon is different from recent year’s cases such as Ghana, Zambia and Sri Lanka in that “the market anticipates that holders will be required to make substantial upfront concessions. That is a different mindset from previous deals and people know they are starting from a different point. We aim to maximize creditor recoveries in a balanced way, and offer more than a one-size-fits-all approach and accommodate different people’s preferences.”

The advisors point out that Lebanon’s substantial gold reserves (valued on May 31 at LBP 2.7 quadrillion or $30.4 billion at the LBP 89,500/$1 exchange rate) represent a rare Lebanese asset of real value, which could be leveraged by BdL to unlock value in support of a future deal. But they recognize it is premature to consider options until the Lebanese authorities and the IMF present a comprehensive plan outlining the country’s assets and liabilities. “To the extent the gold is used purely as a tool of monetary policy in the banking system, for legal reasons it will not be easily accessible to any creditor pursuing a litigation strategy. But it could be a useful element to unlock value in a restructuring in other ways,” Clark says.