DEBT REDUCTION FACILITY FOR IDA ONLY COUNTRIES: PROGRESS UPDATE. Table of Contents. I. Introduction... 1

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized DEBT REDUCTION FACILITY FOR IDA ONLY COUNTRIES: PROGRESS UPDATE Table of Contents I. Introduction... 1 II. Progress With Implementation... 1 A. Overall Progress... 1 B. Progress on Operations Ongoing at the Time of the Last DRF Progress Update... 3 C. Progress on New Operations... 4 III. Current Financial Position Of The DRF... 7 IV. Audits Of DRF Accounts And Operations... 8 V. Challenges... 8 VI. Conclusions BOX Box 1. Estimated Debt Owed by HIPCs to Commercial External Creditors CHART Chart 1. Resources utilized in DRF-supported operations to date... 2 TABLES Table 1. Nicaragua: Results of the DRF-Supported Buyback... 3 Table 2. Liberia: Results of the DRF-Supported Buyback... 5 Table 3. Resources Available to the DRF as of December, ANNEX Annex 1. Background on the DRF Annex Table 1. Summary of Completed DRF Operations Annex Table 2. Non-IBRD Grant Support in DRF-Sponsored Operations to date Annex Table 3. Estimated Commercial External Debt of HIPCs... 21

2 Abbreviations and Acronyms DRF DRFOC EU G7 HIPC IaDB IBRD IDA MDRI SDC SOE Debt Reduction Facility Debt Reduction Facility Oversight Committee European Union Group of Seven Industrialized Nations Heavily Indebted Poor Country Inter-American Development Bank International Bank for Reconstruction and Development International Development Association Multilateral Debt Relief Initiative Swiss Agency for Development and Cooperation State Owned Enterprise

3 I. INTRODUCTION 1. The Debt Reduction Facility (DRF) for IDA-only Counties was established by the Executive Directors of the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA) in July Its objective is to help reforming heavily indebted poor countries (HIPCs) reduce their commercial external debt as part of a comprehensive debt resolution program. DRF support to eligible countries is provided through grants to finance the preparation and implementation of commercial debt reduction operations. Preparation grants help beneficiary countries retain the services needed to prepare the commercial debt buyback operations, and implementation grants finance the actual debt buybacks. A detailed background on the DRF is provided in Annex The increased activity of the DRF in recent years has played a key role in promoting greater creditor participation under the HIPC Initiative. 1 In doing so, the DRF has promoted an equitable burden sharing among creditors of the delivery of HIPC Initiative debt relief. Moreover, the settlement of commercial creditors claims has helped reduce the threat of litigation against HIPCs. The recent DRF-supported operations have also helped HIPCs extinguish some court judgments where litigation had already occurred and judgments had been awarded This report reviews the progress under the Debt Reduction Facility for IDA-only countries since the last progress update to the Board in April The report is structured as follows: Section II reports on the implementation of DRF-supported operations; Section III presents the current financial position of the DRF; Section IV reports on the external audits of the DRF accounts and operations; Section V discusses the challenges faced by the DRF. Finally, Section VI provides concluding remarks. II. PROGRESS WITH IMPLEMENTATION A. Overall Progress 4. Since its establishment, the DRF has supported 25 debt reduction operations in 22 IDA-only countries (see annex Table 1). These operations allowed beneficiary countries to extinguish around US$10.2 billion of external commercial debt. Of this amount, about US$5.0 billion corresponds to principal and US$5.2 billion corresponds to associated interest and penalties. About US$753 million has been used to extinguish these obligations. The operations 1 The role of the DRF in promoting creditor participation under the HIPC Initiative has been highlighted in the 2007, 2008 and 2009 HIPC Initiative and MDRI Status of Implementation Reports ((IDA/SecM , September 6, 2007; IDA/SecM , August 29, 2008 and IDA/SecM , September 16, 2009.) 2 The 2009 HIPC Initiative and MDRI Status of Implementation Report informs of a decline of the number of active litigation cases against HIPCs from 33 to 14 compared to the litigation cases reported by HIPCs in A significant portion of this decline was due to the successful implementation of DRF-supported operations in Liberia and Nicaragua. These figures, however, need to be qualified by the fact that only 25 (out of the 40 HIPCs) responded to the Bank s survey. 3 Debt Reduction Facility for IDA-only Countries: Progress Update and Proposed Amendments to Policies and Practices, IDA/R , April 8, 2008.

4 2 were financed with IBRD transfers of US$266 million, donor grant contributions to specific operations of US$248 million and approximately US$239 million of non-grant financing. 4 A breakdown of the US$248 million of donor grant contribution by donor is presented in Chart 1 below. A detailed breakdown of such contributions by operation is presented in Annex Table 2. Chart 1. Resources utilized in DRF-supported operations to date (US$ million unless otherwise indicated) Total Resources Donor Grant Financing Non grant financing % IBRD % Sweden, 25.2 UK, 19.7 Germany, 19.5 Other, 8.0 France, 17.9 EU, 25.4 USA, 11.9 Russia, 5.0 Finland, 2.0 Japan, 0.6 Canada, 0.4 Donor grants % Netherlands, 31.1 Norway, 37.8 Switzerland, 51.2 Sources: Staff Estimates 5. The pricing of DRF-supported buybacks and creditor participation has varied significantly across operations. The estimated average price, in cents per dollar of principal and interest extinguished, for all operations completed to date is approximately 7.1 cents. 5, 6 Creditor participation rates, measured by claims tendered and resolved as a percentage of eligible debt, have varied from as high as 100 percent in a few cases to as low as 62 percent. (Details are provided in Annex Table 1.) 4 Non-grant financing includes beneficiary countries own contributions towards the buy-back (e.g. the recent Nicaragua buy-back, where US$2.9 million were contributed by the Government of Nicaragua) and loan/credit financing towards the buy-back (e.g. the SDR36 million IDA credit to Côte d Ivoire). 5 Buybacks that were completed up to end-fy04 were priced as a percentage of principal only. Buybacks closed thereafter were priced as a percentage of principal and interest (including, where appropriate penalty interest). For the rationale for the change in pricing strategy see section VI D of the document Debt Reduction Facility for IDAonly Countries: Progress Update and Proposed Amendments to Policies and Practices, IDA/R , April 8, This average was calculated using the estimated price as a percentage of principal and interest (including penalty interest) for the operations closed prior to end-fy2004.

5 3 B. Progress on Operations Ongoing at the Time of the Last DRF Progress Update 6. At the time of the last DRF progress update the operations for Nicaragua and the Democratic Republic of Congo were ongoing. Since then, the operation for Nicaragua has been completed and the one for the Democratic Republic of Congo has benefited from a second extension. Details on both operations are presented below. Nicaragua 7. A DRF implementation grant for a second commercial debt reduction operation for Nicaragua was approved by the Executive Directors in July , 8 Between December 2007 and December 2008 four closings took place under this operation (see Table 1). 9 The first one involved the acceptance of tenders from 12 of the 13 creditors that chose not to participate in the 1995 DRF-supported operation and from 8 suppliers for a total tendered debt of US$1,325.7 million. 10 The three closings that followed involved acceptance of a further 21 tenders all of them from suppliers and SOEs with total claims amounting to US$45.2 million of principal and interest. Table 1. Nicaragua: Results of the DRF-Supported Buyback Date Accepted Tenders Debt Tendered Payment Hold-outs SOEs Suppliers Total (US$ million) (US$ million) First Closing Dec , Second Closing Feb Third Closing Sep Fourth Closing Dec Total , Sources: Staff s estimates 8. This operation resulted in extinguishing US$1,370.9 million of Nicaragua s commercial external debt. This is more than 97.4 percent of the total eligible debt. The 7 The first DRF-supported operation, completed in December 1995, allowed Nicaragua to extinguish around US$1.8 billion of principal and associated interest at a price of 8 percent of eligible principal. Creditors holding around 19 percent of eligible debt chose not to participate. Some of these creditors and/or their assignees subsequently initiated litigation and obtained judgments against Nicaragua. 8 The eligible debt under this operation totalled US$1,407.3 million of principal and interest. Of this, 94.7 percent was owed to 13 hold-out creditors and/or their assignees. The remainder was owed to 6 former foreign stateowned/state-guaranteed enterprises (SOEs) and 99 foreign suppliers. For further details see Proposed Grant of US$61.0 million from the Debt Reduction Facility for IDA-Only Countries to the Republic of Nicaragua for a Commercial Debt Reduction Operation, July 17, 2007 (IDA/R ) and IDA/R Op.Cit. 9 The first closing aimed primarily at hold-out creditors and/or their assignees, which represented more than the 90 percent of the total eligible debt and with whom discussions were at an advanced stage. The multiple closing structure allowed for additional time for discussions with the remaining creditors. 10 Claims from the 12 hold-out creditors accounted for 99 percent of the eligible debt held by these creditors, well in excess of the participation threshold of 90 percent of hold-out creditors claims which was a condition of effectiveness for the grant.

6 4 combined cost of the operation (excluding advisory and external audit services) was US$62.0 million. This cost was financed from bilateral contributions to the DRF(US$28.5 million) from the Government of Nicaragua (US$2.9 million) and from the IBRD contribution to the DRF (US$30.6 million). 9. This operation was of particular significance for the DRF because it retired the claims held by litigating creditors. As part of the terms of the buyback, the litigating creditors agreed to drop their court actions, signed satisfaction of judgment notices, and filed these with the courts following the closing of the DRF operation. In reducing the threat of litigation, these operations also: i) resulted in an efficient management of international reserves, ii) eliminated high legal and transfer costs on international transactions, and iii) contributed to the improvement of foreign commercial relations of the country. Democratic Republic of Congo 10. In May 2009, the Bank approved a second extension of the DRF preparation grant for the Democratic Republic of Congo until June 30, The Executive Directors approved the DRF preparation grant for the Democratic Republic of Congo in September, 2005 and extended it for the first time in May 4, Both extensions were intended to provide the authorities with additional time for preparing a comprehensive strategy for resolving the country s external commercial debt. Despite ongoing discussions with the authorities, the operation continues to face difficulties in reaching the implementation phase. C. Progress on New Operations 11. Since the last progress update Liberia and Sierra Leone have become active DRF countries. The operation for Liberia was completed in April 2009 and the one for Sierra Leone is at the preparation stage. Details on both operations are presented below. Liberia 12. A DRF preparation grant for Liberia was approved by the Executive Directors in April This followed Liberia s clearance of arrears to IDA and IBRD and its arrival at HIPC decision point in March The preparation work financed by the grant complemented the financial support provided by the Swiss Agency for Development and Cooperation (SDC) in the period prior to Liberia s decision point. 13. In January 2009 the Executive Directors approved a DRF implementation grant for a commercial debt reduction operation for Liberia. 13 The grant was used to implement the debt buyback proposed in the Government s commercial debt reduction strategy which aimed at 11 Grant No. TF DRC Preparation of Commercial Debt Reduction Program. 12 Proposed Grant of US$1,300,000 from the Debt Reduction Facility for IDA-only Countries to the Republic of Liberia for the Preparation of a Commercial Debt Reduction Operation, IDA/R , April 15, Proposed Grant of US$39 million from the Debt Reduction Facility for IDA-Only Countries to the Republic of Liberia for a Commercial Debt Reduction Operation, IDA/R , December 24, 2008.

7 5 extinguishing all Liberia s outstanding debts to external commercial creditors. The Governments of Germany, Norway, the United Kingdom and the United States contributed a total of US$22.5 million to the DRF to support the costs of this operation. The Board also decided that the investment income generated by the contributions from these co-financiers would be used to finance the operation The eligible commercial debt under this operation totalled US$1,237 million of principal and interest. 15 Of the eligible debt, US$1,151 million (more than 93 percent) corresponds to financial claims, composed mainly of syndicated commercial bank credit facilities. The remaining US$86 million are claims from suppliers of goods and services (see Table 2). The external commercial claims against Liberia have a number of unusual features that set the case apart from other sovereign debt contexts. For instance, the financial claims had over time been traded in the secondary market and changed hands many times. Moreover, at the time of the DRF-supported operation, virtually all of these claims had traded into the hands of aggressive funds or similar private investment vehicles, some of which had been very litigious in other cases. Table 2. Liberia: Results of the DRF-Supported Buyback Accepted Debt tendered Payment tenders (US$ million) (US$ million) Financial institutions 17 1, Suppliers Total 25 1, Sources: Staff s estimates 15. Following the approval by the Board of the DRF implementation grant, the Government of Liberia launched the buyback operation. The invitation to external commercial claimants to tender their claims was sent on January 12, Based on discussions held with claimants during the preparatory phase, the Government of Liberia made a buyback offer of cents for each dollar of the reconciled outstanding balance (including interest and penalties) as of June 30, The proposed purchase price involved participating creditors 14 The 1989 Board resolution establishing the DRF provides that investment income on donor co-financing is to be credited to the Facility. As a result, the investment income on donor co-financing to prior DRF-supported operations has accrued to a central DRF investment income account to be used for future operations. For the Liberia DRF operation, given the legal constraints faced by some of the co-financiers, the investment income on donor cofinancing was used exclusively for the operation and did not accrue to the central DRF investment income account. 15 For a claim to be considered eligible under this operation, it had to be: i) against Liberia or an agency or instrumentality of Liberia (including the Central Bank); ii) contracted or incurred prior to June 30, 2007; iii) evidenced by a written agreement or financial instrument, and denominated (at the time of the incurrence) in a currency other than Liberian dollars and payable as of June 30, 2007, to a holder, including any court judgments or arbitral awards rendered in respect of any item of eligible debt. For the purpose of this definition a holder means a natural person or a corporation, partnership, business trust, joint stock company, trust, unincorporated association, joint venture or other legal entity, other than: i) any of the foregoing resident in, or having its principal place of business in the Republic of Liberia, ii) a multilateral financial institution, iii) a foreign government (including a foreign export credit agency).

8 6 providing debt relief in terms consistent with the full delivery of their share of debt relief under the HIPC Initiative This operation resulted in extinguishing US$1,205 million of Liberia s commercial external debt. Claimants holding 97.5% of the outstanding debt stock tendered their claims. The Republic of Liberia s paying agent made the closing payments on April 14, The total cost of the operation (excluding advisory, paying agency and external audit costs) was US$37.8 million. Such cost was financed from the US$22.5 million bilateral contributions to the DRF and US$15.2 million from the IBRD contribution to the DRF. The Liberian authorities are currently preparing the tender for a closing audit of this operation. The audit will be conducted in the coming months and will be financed with the proceeds of the DRF implementation grant. 17. This operation retired most of the claims held by litigating creditors. As in the case of Nicaragua, litigating creditors participating in the buyback agreed to drop their court actions, signed satisfaction of judgment notices, and filed these with the courts following the closing of the DRF operation. 17 Sierra Leone 18. On April 24, 2009, the Executive Directors approved a DRF preparation grant to Sierra Leone. This operation aims to settle the holdouts from the 1995 DRF-supported operation. 18 According to current estimates, Sierra Leone s public and publicly guaranteed external commercial debt ranges between US$144 million and US$254 million. The needed financing for an eventual debt buyback will depend on the size of the eligible debt, the buyback price offered by the Government and the share of the eligible debt tendered by creditors. 19. The buyback operation envisaged by the Government intends to facilitate the provision of HIPC Initiative debt relief by commercial creditors. In that regard, it will ensure that commercial creditors are not accorded a preferential treatment compared to bilateral and multilateral creditors. 16 The July 2004 DRF paper ( Debt Reduction Facility for IDA-only Countries Progress Review, Support to the HIPC Initiative and Proposed Enhancements, IDA/R , July 12, 2004) establishes that the debt reduction provided by creditors under any operation supported by the DRF should be no less than the combined reduction applied through the provision of traditional and HIPC debt relief. 17 In this case, however, some creditors not participating in the buyback continued their legal actions against Liberia. Recently, a British Court has confirmed the ruling in favor of two creditors (Hamsah Investments and Wall Capital), which was previously obtained in the New York courts. 18 Sierra Leone benefited from DRF support to complete a debt buy-back in September This buy-back extinguished US$329.5 million of Sierra Leone s commercial external debt (equivalent to a 73 percent creditor participation rate). Of this, US$234.7 million corresponded to principal and US$94.8 million to interest and penalties. These obligations were extinguished at an average price of 13 cents per dollar of principal.

9 7 III. CURRENT FINANCIAL POSITION OF THE DRF 20. As of December 2009, the balance available in the DRF s trust funds totalled US$116.7 million (see Table 3). This is the sum of total balances in the overarching facility fund and the open accounts mapped to the DRF. Table 3: Resources Available to the DRF as of December 2009 (US$ thousands) 1/ Cash balance in DRF TFs as of December, ,705 Less Board approved but so far undisbursed funds earmarked for: Congo, Democratic Republic Preparation Grant 639, 000 Liberia Preparation Grant 300,000 Liberia Implementation Grant 1,208,000 Sierra Leone Preparation Grant 950,000 Total non-earmarked resources available for future operations 113,607 Source: SAP Notes: 1/ The table does not include investment income and balances in closed operations, amounting to a total of US$16,720 thousand. 21. Of the total resources available, US$113.6 million have not been earmarked and are available for future uses. To date, US$3.1 million has been earmarked for specific DRFsupported operations but not yet disbursed. This includes approximately US$1.9 million under preparation grants for the Democratic Republic of Congo, Liberia and Sierra Leone and US$1.2 million under the implementation grant for Liberia. 19 Given the uncertainties surrounding some of these operations, it is likely that not all of the earmarked funds will be disbursed. The unused portion of these resources will be reverted to the core DRF account for its use in future operations. Assuming the historical average price of 7.1 percent and a 50 percent donor cofinancing the non-earmarked resources available would allow to buy back about US$3.2 billion of eligible debt The DRF preparation and implementation grants for Liberia will officially close in June The unused portion of the grants will be reverted to the DRF main account once the final audit of the operation is performed. 20 Whether the price for a debt buyback and donor co-financing are considered adequate for DRF support is determined on a case-by-case basis, following the guidelines in IDA/R and IDA/R Op. Cit.

10 8 22. The total non-earmarked DRF resources available are presumed adequate for the immediate needs. Given the uncertainty regarding future demands, however, a request for replenishment of the DRF core financing over the medium term as well as an eventual extension of the facility cannot be ruled out (see Section V). IV. AUDITS OF DRF ACCOUNTS AND OPERATIONS 23. The DRF s financial reports for FY2008 have been audited by independent auditors (Deloitte and Touche LLP). The auditors report states that the financial statements of the DRF presented fairly the fund balance of the DRF and its cash receipts and disbursements the period ending on June 30, The DRF s financial reports for FY2009 have also been audited by the same independent auditor. The report is not yet available to the staff. 24. The closing audits of the Mozambique operation were submitted by the Government in September 2008 (DRF preparation grant) and December 2008 (DRF implementation grant). 21 The financial statements of the operation for the periods August 20, 2002, to December 15, 2007 (DRF preparation grant) and April 1, 2007 to December 15, 2007 (DRF implementation grant) were audited by an independent auditor (Ernst & Young). The auditor s report for the preparation grant indicates that the auditor was not able to review the consultant selection process for compliance with relevant procurement guidelines. Regarding the implementation grant, the auditor s report indicates that the auditor was not able to review the confirmation of receipts of the payments made to some of the creditors participating in the buyback. 22 Except for the qualifications above, the closing audits find that the financial statements for both grants presented fairly and in all material respects the income and expenditures related to the operation. 25. The Government of Nicaragua submitted the closing audits of the operation in July The financial statements of the operation for the periods April 13, 2004, to December 31, 2008 (for the DRF preparation grant) and August 8, 2007 to December 31, 2008 (for the DRF implementation grant) were audited by and independent auditor (Grant Thornton). The auditor had no reportable findings and has given an unqualified opinion. V. CHALLENGES 26. While the recent progress under DRF-supported operations is encouraging, important challenges remain. First, potential future demands on the DRF could exhaust the resources currently available in the DRF. Therefore the need for a future replenishment of the DRF and for an extension of its mandate cannot be ruled out. Second, given the characteristics of the external commercial claims on potential beneficiaries consisting of a few countries with 21 In October 2007 a DRF-supported buyback helped Mozambique extinguish US$153.2 million of external commercial debt. This operation was intended to address the claims of one major hold-out creditor (Banco do Brasil) from the 1991 DRF-supported operation and three smaller creditors that were not identified at the time of the 1991 operation. The final cost of the debt purchase was US$13.8 million (excluding financial and legal advisory services) and was entirely financed by a contribution from the Government of Norway. 22 As part of the operation, the Bank received certification from the Government's legal advisers that such confirmation of receipt had been received from all creditors. Moreover, the paying agent provided a certification of transfer of funds to all four creditors.

11 9 very large amounts, and many countries with very small amounts, (for details see Box 1 below) the DRF might eventually need to explore modalities of engagement that might be different from the ones that have been frequently used under the facility so far. And third, the recent litigation cases continue to be problematic. The DRF can offer only a limited scope for litigation to be resolved as the Bank has a clear mandate from the Board not to directly intervene in any litigation cases that do not involve Bank-supported operations, except by facilitating the dialogue among the parties involved. Potential future demands on the DRF 27. Given the large volume of external commercial debt claims, the cost of buying back the eligible debt could be considerably larger than the available resources in the DRF. The volume of remaining external commercial claims on the 40 HIPCs is roughly estimated to be between US$11.1 billion and US$12.8 billion (see Box 1). Taking the historic average price of 7.1 cents to the dollar, the cost of buying back these obligations would be between US$789 million and US$909 million. Assuming a DRF contribution of 50 percent of the buyback cost, 23 the facility would require a balance between US$395 million and US$454 million. Given the non-earmarked balance currently available in the DRF (US$114 million), the potential shortfall would be between US$281 million and US$340 million. Under these conditions, to continue financing external commercial debt buyback operations of HIPCs, the DRF would need to be replenished. 28. Not only will more resources be needed, but also the current mandate of the DRF expires on July 31, This follows a five-year extension approved by the Board in April 2007 (see Annex 1). Even in the most favourable scenarios if all potential beneficiary countries were to begin preparations for the buyback operations covering all their remaining eligible external commercial debt, and even if the DRF and donors were to have enough resources to finance these buyback operations, it is unlikely that the beneficiary countries would be able to complete the operations before the current DRF expiration date. 24 Hence, in order to be in a position to continue financing external commercial debt buyback operations for HIPCs, the DRF would require an extension of its closing date. 23 The maximum that could be covered by DRF resources as per current guidelines 24 Based on past performance, some countries could take well beyond 3 years to complete buyback operations.

12 10 Box 1. Estimated Debt Owed by HIPCs to Commercial External Creditors Current estimates indicate that the total commercial external debt of all 40 HIPCs is between US$11.1 billion and US$12.8 billion (see table below and Annex Table 3). 1, 2 Around 80 percent of these estimated amounts are believed to be in interim period countries (between US$4.6 billion and US$4.8 billion) and pre-decision point countries (between US$4.5 billion and US$5.2 billion). The balance of around 20 percent is believed to be in post-completion point countries (between US$1.9 billion and US$2.8 billion). The estimates for each of these categories are dependent on the pace of progress by each eligible country in its respective HIPC process. Box Table 1. Estimated Commercial External Debt of HIPCs (end-2008, US$ million) Minimum Maximum Post-completion point countries 1,874 2,811 Ghana 1/ 928 1,230 Tanzania Other countries 735 1,274 Interim period countries 4,649 4,783 Cote d'ivoire 3,122 3,227 Congo, Republic of 1,207 1,207 Other countries Pre-decision point countries 4,589 5,203 Sudan 4,487 5,101 Somalia Eritrea Total 11,112 12,797 Sources: W orld Bank staff estimates 1/ Includes US$750 million in bonds. 2/ Reflects the outcome of the DRF-supported buyback that took place in A pril These estimates present a significant decline compared to the figures presented in the 2008 DRF progress update. Most of the change is explained by changes in the estimates for Ghana, Liberia and the Republic of Congo. In the case of Liberia and the Republic of Congo the decline compared to previous estimates is explained by their recent debt reduction operations. In the case of Ghana, the increase in the estimate reflects the US$750 million of bonds issued in The remaining smaller changes reflect, in part, the variability of the estimates in different sources. 1 HIPCs refers to countries which have been assessed to meet the HIPC Initiative income and indebtedness criteria as at end-2004 and might wish to avail themselves of debt relief under the HIPC initiative. 2 These preliminary upper and lower bound estimates for the commercial external debt in each country draw upon available sources of information (e.g. HIPC country documents, World Bank s Debtor Reporting System, HIPC/MDRI status of implementation reports, country authorities documents, joint Bank/Fund DSAs). When estimates as of end were not available, estimates for previous years were carried forward using an indicative interest rate of 7 percent.

13 Moreover, there remain considerable uncertainties at this time that make it difficult to anticipate specific amounts of resources and the timing for a replenishment request and for an extension of the DRF closing date, respectively. The uncertainties arise from the following circumstances: The amounts of the external commercial claims and their eligibility for DRF support are uncertain. The estimated amounts of remaining external commercial claims, cited above, are only rough estimates, and their eligibility for DRF support has not been evaluated. 25 On the one hand, the amounts could be lower: a portion of those claims may be ineligible for treatment under the DRF. This could be the case, for instance, if specific claims are collateralized and/or guaranteed, which would make the obligations automatically ineligible for DRF support, based on the rules as approved by the Board. On the other hand, the amounts for certain countries could be larger: external obligations owed by HIPCs to foreign publicly owned enterprises that operate on a commercial basis are eligible for DRF support, but such obligations are not included in the estimates above. It is uncertain whether and when eligible countries would wish to avail themselves of DRF support. The eligible HIPCs do not necessarily request DRF support. Key technical elements in DRF-supported operations remain uncertain until such operations are actually executed. This includes uncertainty regarding the buyback price and the corresponding resources needed. 30. Going forward, therefore, staff aims to focus on refining the estimates of potential financing needs and in evaluating whether a replenishment and/or an extension of the DRF is warranted. Efforts to improve the estimates of the remaining volume of external commercial claims on HIPCs, will then be necessary. Staff will report on these findings in the next DRF Annual Status Report. Modalities of DRF engagement in upcoming cases 31. There are two groups of potentially DRF-eligible countries: those with large stocks of external commercial claims and those with small stocks. This distinction helps identify key technical challenges that the DRF would need to face in the future. For countries with large outstanding stocks of external commercial claims, the issue is availability of adequate resources to finance a DRF financed buyback operation. 26, 27 For countries with small stocks of 25 For details on debt eligibility under DRF-supported operations refer to Debt Reduction Facility for IDA-only Countries: Progress Update and Proposed Amendments to Policies and Practices, IDA/R , April 8, Countries in this category are Sudan, Côte d Ivoire, Republic of Congo, and Ghana which in total represent about 86 percent of the total stock of external commercial claims on HIPCs (see Annex Table 3). Côte d Ivoire and the London Club (to which over 95 percent of the estimated commercial claims are owed to) recently reached an restructuring agreement without support from the DRF. If, in the future, Côte d Ivoire were to request DRF support, it would need to carefully evaluate eligibility conditions (for instance, identify the portion of uncollateralized and

14 12 commercial claims the issue is cost-effectiveness. Experience shows that the quality of the legal and financial advisory services has been essential for the successful implementation of DRF operations. At the same time, these services have been costly and financing them could make relatively small DRF supported operations less cost-effective than in the past (in some cases the cost of the legal and financial advisory services could be close to the cost of the actual buyback of the debt claims). 32. As a result, the DRF would possibly need to explore modalities of engagement in these countries different than the ones used in the more recent cases. Although it is difficult to anticipate the concrete modalities that could be used, some of the avenues to consider are as follows: In the case of countries with large stocks of external commercial debt, the DRF could still facilitate some form of future debt restructuring. For instance, the DRF could finance technical assistance for the preparation of debt restructuring operations (as in the case of Vietnam 1998) or it could finance partial cash buybacks as part of a comprehensive debt restructuring operation (as in the case of Côte d Ivoire 1998). Any such type of support would need to be consistent with the full delivery of HIPC Initiative debt relief, carefully scrutinized in light of current DRF policies and practices. It would also need to incorporate the lessons learned from previous operations. In the case of countries with relatively small stocks of external commercial debt, the priority would be to find innovative means of providing DRF support while maintaining a reasonable cost-effectiveness balance. As indicated in the 2008 DRF Progress Update, requests for DRF support in such countries would be considered on a case-by-case basis. Options to be explored could include a bunching of two or more cases, as already discussed in the 2004 DRF progress review. 28 Arguably, in several of the cases at hand, there could be a critical level of common external commercial creditors holding obligations from countries located in the same geographical region and sharing economic features (such as the CFA zone), both of which would facilitate the regrouping of operations. Such regrouping would need to take into account the size of the stock of external commercial claims that could be treated, and could likely require specific mechanisms to entice the participation by both debtors and creditors. 33. To this end, staff intends to identify more rigorously the characteristics of the external commercial claims of the remaining countries, analyse the associated challenges, un-guaranteed debt that could be eligible). The Republic of Congo recently settled claims from litigating creditors without DRF support. The discount on the face value of the debt that is implied for this operation about 37 percent according to the authorities (if legal and associated fees and court-imposed penalties are excluded). This is well below the 50% threshold consistent with the full delivery of the HIPC Initiative Debt Relief. 27 As an illustration, assuming the historic average price of 7.1 cents to the dollar for all past DRF financed buyback operations, the cost of the buyback for Sudan could be between US$318 million and US$362 million. Assuming that the DRF covers 50 percent of the cost of the operation, the DRF to would need to contribute between US$159 million and US$181 million, when the available non-earmarked resources are only US$114 million. 28 IDA/R Op. Cit.

15 13 and recommend options to respond with more flexibility and efficiency to potential future requests for DRF support. Staff will report on these findings in the next DRF progress update. Risk of Litigation by Hold Out Creditors 34. Some Commercial creditors have exercised their right to launch litigation proceedings against some debtor governments. In cases where judgments were made in favour of the litigating creditors in international courts, the beneficiary commercial creditors could try to enforce them through attachment of assets or financial transactions passing through the jurisdictions where these judgments were issued. 35. In the recent past, the number of litigation cases has dropped thanks to early engagement by debtor countries with their commercial creditors, including through DRF operations. For instance, over the last year, Nicaragua and Liberia saw most of their litigation cases disappear as a result of DRF-supported operations. Indeed, DRF-supported operations have offered a comprehensive framework that the litigating creditors have chosen to participate in and have accepted the terms of the negotiated buyback. In addition, out of- court settlements with litigating creditors have been negotiated by countries such as Cameroon, the Republic of Congo, Sierra Leone and Zambia. 36. Despite these encouraging developments, the litigation threat remains, even after DRF support is provided. For instance, new lawsuits have been initiated last year against the DRC, Sierra Leone, Sudan and Zambia. Furthermore, in recent months, two litigating creditors obtained confirmation by the courts in the UK of a judgment against Liberia previously issued in the New York courts. This decision, which took place after the implementation of the recent DRF-supported operation, involved claims of about US$20 million. The same creditors are currently seeking a further confirmation of the New York judgment in Hong Kong, SAR, China. These are hold-out creditors who had decided not to participate in the DRF-supported operation completed in April The Bank can currently only play a limited role in such litigation cases. OP 7.40 Disputes over Defaults on External Debt, Expropriation, and Breach of Contract establishes that if a dispute is not related to a Bank-financed project the Bank seeks to avoid any involvement in the issue. If no steps are being taken to resolve the dispute and if the existence of the dispute is likely to impair the country s general reputation for business-like dealings, the Bank may urge both parties to act promptly to resolve the dispute. Furthermore, the document Enhanced HIPC Initiative Creditor Participation Issues, 30 approved by the Executive Directors of the Bank and the IMF on April 2003, establishes that in accordance to their respective Articles of Agreement and policies, both institutions are required to operate with neutrality and impartiality in disputes among members or between members and third parties. 38. Several initiatives, however, are currently underway that could help debtor countries that face litigation procedures from external commercial creditors. Donor 29 This case illustrates the fact that a DRF-supported operation cannot eliminate the threat of litigation unless there is full participation of commercial creditors. 30 IDA/R

16 14 countries such as the United States and the UK are considering introducing legislation to curtail the scope of litigation against HIPCs. 31 Also Belgium approved a law to the same effect in May These are welcome developments. Such legislation aims to limit non-participating creditors ability to seek awards from HIPCs via the courts in those countries. In addition, an African Legal Support Facility (ALSF) has been established at the AfDB, with donor support. This facility is mandated to help member countries facing litigation from distressed funds, by assisting them to negotiate complex transactions, and building national capacity to deal with external commercial debt litigation cases. The ALSF is expected to become fully operational in the first half of VI. CONCLUSIONS 39. Very significant progress has been achieved under the DRF. Since its inception, 25 commercial debt reduction operations have been completed with DRF support. These operations allowed 22 countries to extinguish around US$10.2 billion of external commercial debt at a cost of US$753 million. This amount was almost evenly financed from IBRD contributions, donor grant contributions and other non-grant sources of funds. Since the last progress update (April 2008), the operations for Nicaragua and Liberia have been completed. These operations are particularly noteworthy since they included most of the claims held by litigating creditors against these countries and the agreed terms were consistent with the full delivery of debt relief under the HIPC Initiative. It is expected that the current resources available in the DRF will be adequate to cover the facility s immediate needs. However, given the uncertainty regarding future demands a request for replenishment of the DRF core financing cannot be ruled out. Future requirements for the DRF, as well as an eventual extension of the facility, will be discussed at the time of the next progress update in early See "Stop VULTURE Funds" Bill introduced in June 2009 as H.R in the US, and Ensuring effective debt relief for poor countries: a consultation on legislation in the UK. 32 See

17 15 ANNEX 1. BACKGROUND ON THE DRF 1. The Executive Directors of IBRD and IDA established the DRF in July Administered by IDA as trustee, the DRF was established initially for a period of three years but has so far been extended a number of times. Following the five year extension approved by the Board in April , the current mandate expires on July 31, Staff provides periodic updates to the Board on progress under the DRF The objective of the DRF is to help reforming, heavily indebted, IDA-only countries reduce their sovereign commercial external debt as part of a broader debt resolution program, and thereby to contribute to growth, poverty reduction and debt sustainability. 3. The DRF provides support on a grant basis and all such grants require approval of the IDA Board. The DRF provides grants for both the preparation and the implementation of commercial debt reduction operations. 4. The preparation grants provided by the DRF support eligible governments in retaining the professional services necessary in preparing commercial debt reduction operations. Financial and legal advisers are hired by eligible governments in accordance with the Bank s procurement guidelines using grants provided by the DRF. Such advisers assist with the debt reconciliation process to determine the eligible amount; make informal contacts with creditors to determine market expectations; prepare a commercial debt reduction strategy with the Government, in consultation with IDA (as trustee of the DRF); provide advice and opinions on legal issues associated with executing the strategy and, where appropriate, extinguishing the claims; draft the invitation memorandum to creditors and other legal documents; and act as closing agents for the operation. 5. The implementation grants provided by the DRF help eligible governments in financing the costs of debt repurchase as part of the implementation of commercial debt reduction operations. DRF-supported commercial debt reduction operations typically involve a government buying back its public and publicly guaranteed debts from external commercial creditors for cash at a deep discount, thereby extinguishing such debts from the books of the public sector. However, other modalities have occasionally also been used including debt swaps 33 Operational Guidelines and Procedures for the Use of Resources of the Debt Reduction Facility for IDA-only Countries (R89-156, IDA/R89-103, July 13, 1989). 34 Debt Reduction Facility for IDA-Only Countries: Progress Review and Proposed Extension (IDA/R , April 3, 2007). 35 Review of Progress Under the Debt Reduction Facility for IDA-Only Countries (IDA/R92-26, March 9, 1992); Review of Progress Under the Debt Reduction Facility for IDA-Only Countries (IDA/R93-114, July 20, 1993); Debt Reduction Facilities for IDA-Only Countries Progress Report (IDA/SecM94-29, September 14, 1994); Review of Progress Under the Debt Reduction Facility for IDA-Only Countries (IDA/R95-100, June 12, 1995); Review of Progress Under the Debt Reduction Facility for IDA-Only Countries (IDA/R98-107, July 10, 1998); Progress Review: the Debt Reduction Facility for IDA-Only Countries (IDA/R , July 25, 2001); Debt Reduction Facilities for IDA-Only Countries Progress Review, Support to the HIPC Initiative and Proposed Enhancements (IDA/R , July 12, 2004); and Debt Reduction Facility for IDA-Only Countries: Progress Review and Proposed Extension (IDA/R , April 3, 2007).

18 16 (which have been part of operations in Niger, Bolivia, Zambia, Albania, Senegal and Tanzania); and debt restructurings (used in the case of Vietnam and for a substantial part of the debt reduction in Côte d Ivoire). 6. Since its inception, the DRF has played a significant role in extinguishing commercial external debt for low-income countries where high debt burdens have constrained economic growth and poverty reduction. The DRF promotes creditor participation under the Heavily Indebted Poor Countries (HIPC) Initiative an issue on which the Boards of both the Bank and the Fund have repeatedly expressed concern. As such, it helps reduce the risk of non-concessional creditors taking advantage of debt relief provided by IDA and other Multilateral Development Banks under the Multilateral Debt Relief Initiative (MDRI). Settlement of commercial claims, which are generally in arrears, may also help to improve the climate for foreign direct investment and trade. Moreover, the settlement of arrears with commercial creditors enables countries to manage their debts and reserves in a more cost effective way by reducing the incentives for creditors to sell such debts to aggressive distressed debt funds 36, by avoiding expensive litigation and by avoiding the consequent court judgments, the high statutory interest rates on such judgments and attempted attachment of assets. In some cases, the DRF can help HIPCs extinguish court judgments where litigation has already occurred and such judgments have been awarded. 7. The DRF is financed from transfers from IBRD and grant contributions from other donors, as well as investment income earned on such contributions. At its inception, the DRF was funded with a US$100 million transfer from IBRD s FY89 net income. This was subsequently replenished by US$100 million from IBRD s FY93 net income; US$100 million from IBRD s FY95 net income; and US$50 million from IBRD s FY04 net income. In addition, bilateral donors, including Canada, Finland, France, Germany, Norway, Netherlands, the Russian Federation, Sweden, Switzerland, the United Kingdom, and the United States have contributed grants to the DRF for support of commercial debt reduction operations; and the European Commission, France, Germany, Japan, Switzerland and the United States have made grants directly to debtor governments in support of DRF-sponsored operations. Governments own financing resources have also contributed to DRF-supported operations. 8. In 2006, changes were made to the management of the DRF. In March 2006, responsibility for managing the DRF was transferred from the Infrastructure Economics and Finance Department in the Infrastructure Vice-Presidency to the Economic Policy and Debt Department in the PREM Vice-Presidency. In July 2006, a new Debt Reduction Facility Oversight Committee (DRFOC) was established, chaired by the Vice President of PREM and reporting to the Managing Director responsible for PREM, the Chief Financial Officer and, on country-specific matters, the Managing Director for the relevant region. 36 Distressed debt funds, sometimes referred to as vulture funds, are specialized asset management funds which buy the sovereign debts of low income countries from other creditors at deep discounts and then attempt to obtain a settlement with the debtor on substantially better terms than those that they paid. They frequently engage in litigation to obtain judgments against the debtor, often at a full contractual valuation of the principal, interest and penalties. They then exert pressure on the debtor by attempting to obtain attachment of the Government's assets abroad. Through such strategies, such funds attempt to maximize their returns in any ultimate settlement.