Sénégal: Total Return Swaps Debt Restructuring Raises Creditor Risks

• Sénégal is restructuring debt complicated by 721 billion CFA francs ($1.24 billion) raised through opaque total return swaps (TRS).
• TRS are derivatives, not loans, often undisclosed, where states pledge their own bonds as collateral to banks for financing.
• This arrangement risks subordinating traditional bondholders to banks, as seen in Ecuador's 2020 repayment to banks before its bond restructuring.
• Bondholders, represented by White & Case, argue these financings should be included in Sénégal's restructuring, a view supported by the IMF.
• The lack of prior sovereign TRS restructurings makes Sénégal a critical test case for how these instruments will be treated.

The absence of any known prior sovereign total return swap restructurings underscores the unique and challenging nature of Sénégal's current predicament.

Sénégal is currently navigating a complex debt restructuring, a process complicated by the emergence of substantial undisclosed financial instruments known as total return swaps (TRS). These arrangements, which have allowed the nation to secure 721 billion CFA francs, equivalent to $1.24 billion, pose a significant challenge to the traditional hierarchy of creditors. The use of TRS, a product long favored by speculative funds, risks placing conventional bondholders in a subordinate position to the banks involved in these transactions.

This financing mechanism involves a sovereign state pledging its own bonds as collateral to banks in exchange for funding. While offering a seemingly attractive solution for countries facing liquidity constraints, the opaque nature of these deals has raised concerns among investors and legal experts alike. Other African nations, including Angola and Nigeria, have also utilized similar structures to raise billions from financial institutions, highlighting a growing trend in sovereign financing that introduces new complexities into debt management and restructuring efforts.

The fundamental structure of a total return swap involves a state issuing its own obligations, but instead of selling them directly to market investors, it provides them to a bank as security for a loan. The state then pays a fee to the bank, which is offset by the coupons the bank returns. For governments in need of immediate capital, this method can provide swift financing, often without the extensive scrutiny associated with traditional bond markets and potentially at a lower cost.

However, a critical distinction lies in their classification: TRS are typically categorized as derivatives, not conventional loans. This classification means they are not always reflected in publicly disclosed financial statements, leading to a significant lack of transparency. Bondholders and credit rating agencies may remain unaware of which countries have entered into these agreements, the specific amounts involved, or the precise terms and conditions. Furthermore, the nominal value of the bonds pledged as collateral frequently far exceeds the actual amount borrowed; for instance, in Angola, the collateral was double the borrowed sum, and an Ecuador deal in 2018 saw a collateralization rate of 240%, meaning $240 of debt was pledged for every $100 borrowed. Lee Buchheit, a former Cleary Gottlieb lawyer renowned for overseeing numerous sovereign debt restructurings, points out a core issue: the borrower pledges its own liabilities rather than tangible assets like gold or U.S. Treasury bonds. Should a nation's financial health deteriorate, these pledged securities lose value, compelling the state to provide additional bonds or cash, often at the most inopportune moment. Angola, for example, had to pay JPMorgan $200 million in January when declining oil prices eroded the value of its collateral. Buchheit warns that if banks resell these titles, the state's debt could increase "much more than the cash received."

Sénégal's current situation is being closely watched as a real-world test case for how these complex total return swaps will be handled in a sovereign debt restructuring. The 721 billion CFA francs secured by Dakar came from a consortium of lenders, including Africa Finance Corp., Société Générale, and First Abu Dhabi Bank. While the Senegalese government indicated a borrowing cost of approximately 7% for these arrangements, significantly lower than the estimated 11% to 12% on global markets, it has not provided further details.

A central unresolved question, as highlighted by Bloomberg, pertains to the treatment of these TRS within the restructuring framework. Specifically, there is uncertainty regarding whether the contractual terms of these agreements might grant the lending banks priority repayment, allowing them to be settled before any comprehensive agreement is reached with other creditors. Bondholders, represented by the law firm White & Case, contend that these financings, provided by international investors in foreign currency, should be fully integrated into the broader restructuring process. This position is supported by the International Monetary Fund (IMF), which classifies such instruments as external debt.

The absence of any known prior sovereign total return swap restructurings underscores the unique and challenging nature of Sénégal's current predicament. This lack of precedent leaves legal and financial advisors navigating uncharted territory, with the potential outcomes setting important benchmarks for future sovereign debt crises involving similar instruments. The experience of Ecuador offers a cautionary tale; in 2020, the country repaid $1 billion to Goldman Sachs and Credit Suisse *before* proceeding with the restructuring of its dollar bonds.

According to Fitch Ratings, as cited by Bloomberg, this pre-restructuring repayment meant that bondholders subsequently incurred heavier losses than they would have if the banks involved in the TRS had participated in the broader debt relief efforts. Former World Bank President David Malpass has articulated a concern that these types of secured loans, including those utilized by Sénégal and Angola, are effectively creating "a new race to seniority" within the capital structure of sovereign debt. Among the financial institutions involved, First Abu Dhabi Bank has been specifically noted in connection with these arrangements.

Lawyers advising creditors in sovereign debt restructurings, particularly in African jurisdictions like Senegal, must be vigilant for undisclosed total return swap (TRS) arrangements. These instruments, often classified as derivatives, can create hidden seniorities, potentially subordinating bondholders' claims and leading to more significant losses if not properly identified and addressed during negotiations. It's crucial to understand their legal classification and potential impact on debt priority.

Source: Original reporting via SenePlus