Sovereign Debt Remedies in Mexico

Rosa María Rojas Vértiz C.[1]

I. Introduction. II. General Remedies. III. Financial Discipline for States and Municipalities in Mexico. IV. Benefits and Pending Matters. V. Conclusions.

  1. Introduction.

This paper addresses the status of sovereign debt remedies in Mexico. First, it will make a reference to the remedies Mexico has adopted in the international arena. Secondly, it will focus on the rules it has established within the country to control and surveildebt incurrence by subnational entities.

The recount of such rules will be followed by some comments, which on one hand point out the benefits of the regulations, and on the other hand, relate pending issues,and matters which may be improved in the future.

  1. General Remedies.

In Mexico, as I believe is the case in Latin America and most civil law countries, there is no statutory proceeding for the restructuring of sovereign debt, including debt of municipalities or public entities, as there is a Chapter 9 of the Bankruptcy Code in the United States of America.

The Mexican Bankruptcy Law (Ley de Concursos Mercantiles) is applicable only to businesses, either companies or individuals. Notwithstanding how unbelievable it may be, there is no actual insolvency proceeding for entities or persons other than businesses in Mexico. The bankruptcy proceeding that could be applied to individuals or non-business entities was drafted and incorporated into the Civil Code in 1928, and has not been amended since then, so it has turned obsolete and it is not in use.

Moreover, even considering that the proceeding contained in the Civil Code is in effect, and therefore, could be applied upon request by a debtor, it is not applicable to public entities, but only to individuals, and it is arguable if it may be applicable to private non-commercial entities.

Accordingly, Mexico, its states, municipalities and public entities may only solve insolvency issues through restructuring agreements with their creditors, adjustments in the budget, includingdecreases in current expenditure, or adjustments in taxes, among other measures.

It must be acknowledged, however, that in the last 20 years the Federal Mexican Government has taken appropriate measures to adjust sovereign debt to the new standards and to improve its terms and conditions. The International Monetary Fund reports that Mexico was the first country to include Collective Action Clauses (CACs) in its sovereign bond issue in the New York market in February 2003.[2]

The International Monetary Fund recommended the inclusion of CACs replacing unanimous action clauses in bond issues, in order to avoid the need of the unanimous consent of all creditors for a restructuring agreement to be successful. Introducing CACs neutralizes potential holdouts from creditors, usually vulture funds, which buy sovereign debt claims at a deep discount in secondary markets and then sue for full repayment, taking advantage of the unanimous consent requirement to hinder an agreement, as we have recently seen in Argentina.

However, the Mexican Government had an important pending matter: establishing a clear and firm regulation to control and appropriately surveil public debt incurrence by subnational entities.

The Ministry of Finance and Public Credit (hereafter, the “Ministry of Finance”) did carry a registry of the debt incurred by the States[3] since at least 1978,[4]but it was limited to debt to be repaid with participations in federal taxes States received.

Mexico has a very complex taxation system, where most taxes are collected by the Federal Government; then, the Federal Government enters into agreements with each State and, subject to fulfillment of certain conditions, it delivers to each State a percentage of the federal taxes collected during each fiscal year. Generally, an amount of such participations is previously allotted to the fulfillment of financial obligations assumed by the State, which had to be registered with the Ministry of Finance.Subject to certain rules, each State could decide the destination of the remaining amount.

Therefore, excepting financings guaranteed by the Federal Government or repaid with participations in federal taxes, there was no general registry of public debt incurred by States, and accordingly, an absence of control on the debt arrangements entered by the States conforming the Union.

On the other hand, the fact that the Mexican Constitution does not allow States to acquire debt in foreign currency, from foreign entities or debt payable outside the country,[5] did not prevent local public debt increasingfrom 1.7% of the National Gross Domestic Product in 2008 to approximately 3% in 2015. This is, sub-national public debt duplicated in less than 7 years.

The absence of control and the predominant use in recent years of multiple financing structures, other than credit facilities, such as securitizations and public-private partnerships, which may not be reported as they are not deemed loans, caused a substantial increase in the public debt incurred by the States in a relatively short period of time.

  1. Financial Discipline for States and Municipalities in Mexico.

The foregoing caused a major concern in several sectors of civil society and the government, which led to a Constitutional reform published on May 26, 2015,to establishparameters addressed to control public debt incurred by the States.

The reforms provided that the Congress should pass a law setting forth the general basis on which States may incur indebtedness, as follows:

  • The law should establish limits and the mechanisms under which States can compromise their participationsin federal taxes;
  • The obligation to register and publish all their indebtedness and payment obligations in a Debt Public Registry to be handled by the Ministry of Finance;
  • An alert system for public indebtedness which shall also be handled by the Ministry of Finance;
  • Penalties for public officials that fail to comply with the obligations to be set forth in the law;
  • The creation of a special commission integrated by members of the Federal Congress in charge of reviewing the strategy to adjust the budget and policies to be adopted by States with a high level of indebtedness, as a pre-requisite to receive federal participations;
  • The authorities of a Federal Supervising Entity (Auditoría Superior de la Federación) were strengthened, and in addition to surveil and conduct due diligence on the use of the federal funds received by the States, it can also trace federal public funds when transferred to trusts, other vehicles or private entities.
  • State’s legislatures, with the votes of 2/3 of its members, shall establish upper debt limits within each State.

On April 27, 2016 was published the Law of Financial Discipline for States and Municipalities(hereafter, the “Law”).

The Law is addressed to States and municipalities, including all public entities therein, and any entities controlled by any of the foregoing, and covers any transaction that originates a debt, either direct or indirect, short, medium or long term, derived from a loan, credit facility, leasing or factoring, regardless of the form in which it is implemented. The Law refers expressly to public-private partnerships, but it is arguable if includes obligations arising under securitizations.

The main obligations the Law imposes on States are as follows:

  1. Annual Budget.It provides that revenue bills and budgets of the States must include:
  • Annual objectives, strategies and goals;
  • Public finance projections;
  • A description of the relevant risks for the State’s public finance, including amounts of contingent debt, and a proposal of remedies;
  • A result of the State’s public finance relating to the last 5 years;
  • An actuarial study of labor pensions, including the number of affiliates, average age, benefits granted, and the amount of reserves for pensions.
  1. Negative Balance.The Law foresees the possibility of a negative balance. In such case, the State’s Governor must account to the Statelegislature the reasons for such negative balance and explain the remedies available, the specific amount of resources required to adjust the balance and the sources from which such means will be obtained, as well as, the number of fiscal years required to have a positive balance. Quarterly reports must be made to the federal authorities, and published in the State’s official web page.
  1. Expenses.Every proposal to increase or introduce an expense must be justified with the corresponding revenue. States must also adopt measures to decrease current expenditure. The Ministry of Finance of each State must make an estimation of the impact that may have in the budget any law that is proposed to the legislature.
  1. Natural disasters. The annual budget of the States must include reservesto be used to repair the damage that may be caused to public infrastructure, and to the population that may be affected, by natural disasters, as well as, actions to prevent them and to mitigate their impact in the State’s public finance. It is expected that the reserves go up to a 10% of the amounts allotted by the State to repair natural disasters in the last 5 years.
  1. Public employees’ remuneration. Remuneration of public employees in each budget shall have as an upper limit the amount approved in the previous fiscal year plus any real growth in the gross domestic product.The budget must have a special section detailing all payments to be made to all public employees, including any extraordinary compensations and social security, as well as, the sources for any increase in salaries, new positions and any other benefits.
  1. Public-private partnerships. Budgets must also contemplate all payments to be made under any public-private partnerships in effect or to be entered by the State in the fiscal year in question.If the State or any of its public entities wants to enter into a public-private partnership, it must justify the convenience of using such scheme in comparison with a traditional mechanism, as well as, an analysis of risk transfer to the private sector. Such evaluations must be public, and therefore, published in the official web page of the State.
  1. Excess revenues. Resources obtained during any fiscal year in excess of those contemplated in the revenue bill, which are not compromised, must be allotted as follows:
  • At least 50% to the repayment of public debt, to the extent anticipated repayment is allowed without penalties and it reflects a decrease in the debt balance, as well as, to the payment of judgments and the creation of funds for natural disasters.
  • The remaining amount must be allotted to productive public investment through a fund created to that effect, and to compensate the decrease in the revenue that is not compromised for subsequent fiscal years.
  1. Indebtedness Upper Limit.Each State legislature must establish, with a vote of 2/3 of its members, the indebtedness upper limit of the State, after reviewing the payment capacity of the State or public entity, the destination of thefinancing resources, and the assets to be used for repayment orto be granted as security, if any.

However, the Law provides that authorization from the legislature will not be required for refinancing or restructuring transactions, to the extent the interest rate and associated costs are lowered, the outstanding amount of principal is not increased and repayment terms are not lengthened. In such scenario, the Governor must only notify the legislature and register the transactions within 15 calendar days following the closing date.

  1. Transparency.Disbursement of the financing is subject to the registry of the transaction in the Debt Public Registry, except bond issues or obligations payable within 3 months, in which case, it will suffice if the financing is registered within 30 days following the closing date.

Also, within 10 days following registration with the Debt Public Registry, the State, municipality or public entity must publish the transaction documentsin its official web page. All concepts representing a cost to the State or the public entity must be published. Public entities must prepare quarterly reports showing detailed information of each financing, such as, interest and principal payments, fees, terms, and any other payments to be made thereunder.

  1. Best Market Conditions. States and municipalities must be able to prove that they selected the financing with the best available conditions in the market.

For that purposes, when the financing exceeds an amount determined by the law (approximately US$12’000,000.00 for States and US$3’000,000.00 for municipalities), and it is repayable over a year term, the public entity must show that it started negotiations with at least 5 financial institutions and obtained at least 2 offers detailing all terms and conditions applicable to the financing.If the amount of the financing is lower, the public entity must be able to show it dealt with at least 2 financial institutions. A document containing the comparative analysis of the offers must be published in the web page of the public entity, State of municipality.

The same is applicable to leasing transactions and public-private partnerships; on the understanding that the public entity is bound to publish all items representing a cost or expense.

If the financing is obtained through a bond issue, the public entity does not need to show it has dealt and received offers from different financial institutions, but it must state in the documentation why the bond issue was a better option and publish all costs and expensesassociated to the transaction.The National Banking and Securities Commission must publish rules detailing the information to be published, including a comparative of costs associated to similar transactions in the market.

When the financing exceeds an approximate amount of US$30’000,000.00, the financing must be obtained through a public tender.

  1. Short Term Financing.As an exception, the law allows States and municipalities to hire short term financing without the legislature’s authorization, as long as:
  • The full outstanding amount of the obligations deriving from such financing does not exceed 6% of the total revenues approved in the revenue bill, not taking into account net financing;
  • Short term obligations are totally paid at least 3 months before the end of the corresponding administration, on the understanding that no financing can be hired during the last 3 months of the governmental period;
  • Repayment must not be subject to any type of guarantees or security interests; and
  • It is registered in the Debt Public Registry.

Short term financing can only be hired to solve temporary liquidity problems, and cannot be refinanced or restructured for repayment over a year.

  1. Federal Government Guarantee.The State interested in obtaining a guarantee of the Federal Government on its debt must:
  • Enter into an agreement with the federation that provides (a) the limits of indebtedness applicable to the public entity, and (b) other public finance goals, such as, the gradual decrease of any negative balance, the reduction of current expenditure and the increase of local revenues; and
  • Assign a sufficient amount of its participation in federal taxes.

States may only enter into such agreements with the Federal Government with the approval of the legislature. The agreements must be published on the Federal Official Gazette and on the Official Gazette of the corresponding State.

If the State wants to obtain a guarantee of the Federal Government on the debt of its municipalities, then it must enter into an additional agreement.

The total debt held by theStates in the Union with the guarantee of the Federal Government shall not exceed 3.5% of the National Gross Domestic Product for the previous fiscal year. The debt of each State or municipality with the guarantee of the Federal Government cannot exceed 100% of its revenues contemplated in the revenue bill, which are not assigned to a specific purpose.

When a State has a high level of indebtedness, according to the alert system to be explained later, a special commission integrated by members of the Federal Congress is in charge of reviewing the strategy to be followed to adjust its budget and policies, which strategy must be set forth in the agreement to be entered with the Federal Government. The Commission must provide comments within the 15 business days following receipt of the draft agreement. After execution, final agreements must be delivered to the Commission.

States and municipalities shall send quarterly reports for the evaluation of the goals set forth in the agreements. Results of the evaluation must be published in the official web pages of the States and of the Ministry of Finance.

If any State or municipality defaults the obligations set forth in the agreement, it won’t be able to obtain further guarantees from the Federal Government, and shall be bound to pay the cost associated to the debt guaranteed by the Federal Government and/or repayments of guaranteed debt may be accelerated. The Ministry of Finance may upon a default rescind the agreement. Rescission should be published in the Official Gazette of the Federation.

  1. Alert System.The Ministry of Finance must evaluate the public entities that have obligations registered with the Debt Public Registry. To that effect it shall take into account several financial ratios, such as the maximum leverage ratio, debt service and short term obligations versusall revenues.

As a result, it shall classify the entities either as having manageable indebtedness, indebtedness in observation or high indebtedness. Accordingly, an entity having manageable indebtedness shall have an Upper Limit Net Financing of up to 15% of its revenues not assigned to a specific purpose.

An entity classified with indebtedness in observation shall have an Upper Limit Net Financing of up to 5% of its revenues not assigned to a specific purpose; and an entity classified with high indebtedness shall have an Upper Limit Net Financing equal to cero.

The Alert System shall be published in the web page of the Ministry of Finance permanently, and must be updated quarterly.

  1. Debt Public Registry. The Ministry of Finance shall also carry a Debt Public Registry, where all States, municipalities and public entities controlled by the foregoing, must register all their credit facilities, bond issues, leasing agreements, factoring agreements, guarantees, derivatives –with obligations extending over a year- and public-private partnerships. The registry seeks transparency ofall indebtedness obtained by such public entities.

However, registration is conditioned to fulfillment of all obligations imposed by the Law and other legal provisions applicable to States and municipalities.