Law 26,017 and Legal Subordination: Violation of Pari Passu Clause

http://blog.legalbird.net/law-26017-and-legal-subordination-violation-of-pari-passu-clause.html


Law 26,017 and Legal Subordination: Violation of Pari Passu Clause

By Samir Malik

University of Warwick

I. Introduction

Pari Passu clause is a standard feature of international debt instruments. The Latin phrase pari passu can aptly be defined by using the words “equal treatment”, signifying that on insolvency the unsecured debt represented by the instrument will be treated equally and the interests of such creditor will not be prejudiced by creating a class of creditors with a superior rank . The effects of this clause has been widely discussed and debated both in judicial and academic corridors so as to ascertain whether the clause just determines the rank of a creditor so that he can not be subordinated by the debtor or it directs pro rata payment to the creditors? The balance of judicial and academic authorities lies in favour of the former interpretation .
As undoubtedly a sovereign is not subject to bankruptcy laws and insolvency proceedings hence the role of pari passu clause is different in sovereign debt instruments. This clause basically acts as a warranty that the sovereign will not pass any law to make a legal basis for discrimination and subordination of the creditors . There is nothing in pari passu clause that prevents a sovereign to pay one creditor over the other or repay the debts of most favored creditors like World Bank and IMF . If the creditors intend to protect themselves from such payments they can include other clauses like mandatory payment clause and sharing clauses in their lending agreements . Pari Passu clause does not protect creditors in these circumstances. The purpose of pari passu clause ends with determination and protection of the ranks of creditors it has nothing to do with pro rata payment .
The sovereign debt restructuring have seen some successful use of the pari passu clause by the holdout creditors to compel the sovereign to strike a deal with them before going forward with the restructuring , which have been heavily criticized . Use of this clause against the sovereign debt restructuring has resulted in rise of many critical issues like protection of interest of the hold out creditors vis a vis national interests , breach of pari passu clause, contractual obligations, principle of fair negotiation and good faith . These issues have been surfacing again and again with sovereign debt restructurings and recent sovereign debt restructuring by Argentina and related litigation pending in the U.S courts have again brought them into focus of the lime light. The issues and considerations so emerged are worthy to be assessed before criticizing or appreciating the use of pari passu clause in such events and this work earnestly tries to secure this end.

II. A Brief Background

As soon as crisis hit, Argentina started strategic planning to avoid difficulties caused by litigation of the creditors. All reserves and financial assets were transferred from Deutshe bank, New York to Bank of International Settlements in Basel, Switzerland and to banks in Argentina. This was done in order avoid attachment of these assets in consequence of litigation of the creditors and in April 2002 Argentina declared its default. This default is the biggest and longest ever sovereign default with a total outstanding default of $81.8 billion involving 152 series of bonds, 8 jurisdictions and more than 38 months in default . Argentina also owes to its credit the largest ever nominal value write off of 75% and that is not all Argentina has already defaulted five times since 1890 and possibly would do more . With this default Argentine middle class plunged into poverty and the Italian pension fund holders lost their life long savings.
Argentina offered its final debt exchange proposal in January 2005. The final proposal was preceded by two earlier proposal made in September 2003 (Dubai) and in June 2004. The final offer included a 75% nominal value write off and offered new types of bonds viz. par, discount and quasi par bonds all having GDP warrant. The offer was also supplemented by most favored creditor clause giving right to the new bondholders to participate in future exchange offers. Thereafter Argentina passed law 26,017 authoritatively asserting the above clause , which foreclosed the exchange offer and prohibited the Argentine government to engage in any future negotiation with the hold out creditors.

III. Economic Costs of the Restructuring

Unprecedented hair cut by Argentina has not only resulted in huge economic loss to the creditors but has also caused direct and indirect losses to the global economy According to an estimation the investors who accepted the offer sustained a capital loss of $29.5 billion and loss of $19 billion & $11.2 billion by way of interest payment suspension and loss of investment returns respectively. Those who repudiated the offer suffered a loss of almost $24 billion in the form of capital loss, repudiated interest income and foregone investment return .

IV. Legal Subordination: Meaning and nature

The word subordination is derived from the root word “subordinate”, which means “to place in a lower rank or order” . Contextualizing this word in the sense of the issue in question subordination means the effect of any act of the debtor implicitly or explicitly lowering the place or rank of the creditors represented by the debt instrument in question. The rank or place of a creditor can be lowered if the debtor by any way creates new class of creditors whose rights ranks superior to him.
Legal subordination in the same sense refers to any such act of the sovereign which is having a color of law and legally provides grounds for subordination e.g. passing a law resulting in subordination. The concept of legal subordination forms the bedrock of the this work and thus is of great importance for the current analysis as the purpose of existence of pari passu clause in sovereign debt instruments is to specifically protect against legal subordination .

V. Law 26,017: Legal Subordination of the Holdout Creditors.

“Rogue debtors, rather than rogue creditors, are the ones that pose the greatest threat to the integrity and efficiency of the international financial architecture (Porzecanski)”
Argentina through out the restructuring tried hard to attract all creditors to participate in the exchange offer; however it could not manage to attract 24% of its creditors who preferred to holdout. The participating creditors were treated favorably and the interests of the hold out creditors were subordinated . This has led to some very serious issues about the voluntary nature of the debt restructuring. An offer which is based on “leave it or take it” principle shall fail to pass the test of volunatriness particularly in the circumstances when the creditors are put in such a situation where they have no other option but to accept the unfavorable terms. Those who participated in the exchange offer were rewarded by the most favored creditor status and cash rewards and the holdouts were punished by the so called “padlock law”. This law strengthened the position of the participating creditors and subordinated the interests of the holdouts.
This law is a good example of the display of power of a sovereign against relatively ill equipped creditors . The sovereign shoulders of Argentina pushed the holdouts into the danger zone of loosing all of their legal claims and the recent decision of American Supreme Court has finished all hopes of these holdout creditors . The law 26,017 not only leads to clear violation of basic principles law of contract, good faith and fairness, but is also tantamount to legal subordination of the creditors, which is not allowed under the pari passu clause.
In NML Capitals ltd v The Republic of Argentina even though the issue of pari passu clause was not raised by the creditors, the fear of pari passu clause made Argentina to speculatively defend itself on its violation . Argentina asserted that the payment interpretation of the pari passu clause is wrong and that the rankings of the holdouts have not been interfered with in any way . The holdout creditors probably did not raise claim of breach of pari passu clause as upto now the U.S courts have not adjudicated this issue of violation of pari passu clause and they would be the first to make U.S courts to do this. This decision may also have been based on the severe criticism of Elliot judgment however it is believed that the creditors lost a lethal weapon against Argentina by failing to claim the breach of pari passu clause . Strength of this assertion lies in the fact that the passage of law 26,017 has squarely brought the whole case within the sphere of operation of pari passu clause .
The legal subordination of the holdouts and consequently the violation of the pari passu clause can easily be demonstrated by analysing the effects of the padlock law. This law was passed with an objective of concretizing the grounding of the most favored creditor clause , thereby placing the participating creditors over and above the holdouts. The act of providing a legal basis for elevating their position over the holdout creditors creates a naked violation of pari passu clause which but for this law would have been a grey area and an object of argument.
An analysis of Article 2, 3 and 4 of the law further buttress this argument of legal subordination. Article 2 prohibited the Argentine government to reopen the offer in relation to the bonds subject to the exchange offer, which has an effect that no further offer would be made to the hold out creditors leaving them gasping for air. Article 3 proceeded with the same theme of subordinating their interests by leaving no space for them to settle their claims by negotiation with Argentina and the doors of the Argentine courts were closed forever for them. When this article is read with the “most favored clause” the consequences becomes more tragic as first of all chances of settlement of their claims through negotiation or domestic judicial intervention are almost brought down to nil and secondly the ramifications of “most favored creditor” clause would compel Argentine government to fiercely oppose any move of these creditors to settle the claims by any means because in case they succeed to obtain a better deal than the participating creditors then Argentina will be bound to offer the same deal to all of the creditors, which would not be acceptable to it at any cost. Moreover the number of holdout creditors is also not insignificant as it was in other sovereign debt restructuring, which makes it highly improbable that Argentina would prefer a settlement. All this would mean that the debt not swapped would remain defaulted indefinitely.
The bonds of the holdout creditor are rendered worthless by Article 3 which directs the government to de-list the bonds from all stock markets wherever they were listed. This will virtually turn the bonds into worthless pieces of paper as the creditors would not be able to trade them in the stock market. The rights of these creditors are in a very feeble state and if law does not come to their rescue their interests will be burnt into ashes.
An analysis of the effects and interpretation of the law taking into account all of the circumstances of the Argentine restructuring leaves a little doubt that this series of events has led to subordination of the holdout creditors and has undoubtedly placed them in a completely disadvantageous position.
In this view the words of Porzecanski quoted above are fair enough to take a caution of the rogue debtor rather than rogue creditors, because the so called rouge creditors (perhaps the vulture funds) do contribute much, they act as a balancing force in favour of a better deal for the creditors and more often they are a good market for the creditors who can not sustain long fight against the sovereign to claim their money and are in need of immediate liquidity . An individual creditor is rather too weak to correct the wayward debtor as Porzecanski further says “the sad truth is that only other governments . . . can hope to rein in a wayward sovereign debtor and persuade it not to walk away from its lawful obligations” .
The saddest part of this story is that even the courts although recognizing the rights of the creditors denied any remedy to the creditors, which reminds me of a Latin maxim “ ubi jus ibi remedium” (where there is a right there is a remedy) so what is the importance of having a right for which no protection or remedy is provided?

VI. Contractual Obligations, Principles of Voluntary Participation and Good

Faith.

A sovereign debt instrument is undoubtedly a contract between the debtor (sovereign) and the creditor upon the terms agreed between them in the prospectus. This contract entails obligations upon both of the parties. This is a commercial transaction and no sovereign immunity is available to any state that has borrowed loans by issuing debts . In this context a sovereign should not be allowed to run away from his obligations by merely asserting that he is acting in the financial and national interest of his country. Even when there is an immediate and urgent need to act for the interest of the nation the interests of the creditors should also be respected. The national interests should be properly balanced with the interests of the creditors and international financial system as a whole. Further, it is a cardinal principle of the law that the contracting parties must perform their legal obligations as agreed.
While dealing with the litigations relating to sovereign debt the courts ought to consider that the debt was contracted by the sovereign for his need of finance and later on at the time of repayment/restructuring no allowance to frustrate the legal claims of the creditors should be made. As far as possible sovereign should not be extended more benefits than that of a commercial debtor, at least he should be prevented to exploit his sovereign capacity to bargain favorably at the time of restructuring as happened in case of Argentina debt restructuring .
Any unilateral action, prejudicing the interests of the creditor such as leave it or take it offer should be discouraged in the interest of the global financial system and market discipline. The participation in such restructurings as of principle is voluntary and the preservation of sanctity of this principle is responsibility of all involved and particularly IMF. The Argentine restructuring has completely flouted this principle. The prospectus supplement dated 27.12.2004 issued by Argentina contained a threatening clause specifying that “eligible securities that are not tendered may remain in default indefinitely” and it was made clear that it had no intention of resuming payments on any eligible securities that remain outstanding. It seems that Argentina was warning creditors either you accept the offer or you will be given nothing. This modus operandi for securing restructuring should not be considered appropriate and is against the principle of good faith of IMF which encourage sovereign to engage in negotiation with the creditors and provide solutions to the creditors who do not participate
.

VII. Remedies for the Holdout Creditors

In case of violation of pari passu clause creditor’s remedies are that of an unpaid creditor . These creditors can approach the court for attachment or a restraining order . In addition the creditors may also seek arbitration of the dispute if the defaulting sovereign has signed arbitration treaties, apart from these formal remedies IMF and countries like USA may come to their rescue and compel the sovereign to honor its financial obligation. Restrictions in access to international debt market may also compel the sovereign to strike a deal with the holdout creditors. However Argentina debt restructuring has seen none of them. Neither USA nor IMF encouraged Argentina to negotiate and enter into a compromise with the holdout creditors and further the U.S Court of appeal for the 2nd circuit denied attachment of funds of Banco Central de la República Argentina deposited at the Federal Reserve Bank of New York on the ground of sovereign immunity and the same court had earlier denied to attach the bonds tendered (subject to the exchange offer) to Argentina confirming the reasoning of the district court that the attachment order will hamper the conclusion of the exchange offer .
The doors for negotiation with Argentina have already been closed by law 26,017 and in these circumstances the future of the rights of these creditors looms in dark, which I think should not have been allowed to happen. The courts ought to have balanced the legal rights of the creditors with that of national interests of Argentina keeping in view the unprecedented and huge haircut.

VIII. Conclusion

Argentina debt restructuring has proved to be a perfect example of use of sovereign capacity to bargain favorably and now it has been accepted that the sovereign do use such tactics to strike a favorable terms in restructuring. Such practices are to be discouraged and condemned in the interests of the global financial system. It is agreed that restructurings are necessary for the financial health of a nation however this should not be secured at the sacrifice of settled principle of law and sanctity of these principles like principle of pair passé, good faith and voluntary participation should be preserved.
Argentina debt restructuring has raised some serious issues about subordination of the creditors and the breach of above mentioned principles. Inter-alia passage of law 26,017 is most detestable in view of the well accepted import of pari passu clause that the sovereign should not create a legal basis for discrimination amongst the creditors which is a natural and direct effect of this law and this is the basis which has made this case completely different form the decision of Elliot case . An analysis of the law has made it clear that the law has not only made the bonds of the holdout creditors worthless but has also created a superior class of creditors comprising of the participating creditors. The interests of the non participating creditors have been clearly subjugated and suppressed, which has led to complete frustration of the object of the pari passu clause in sovereign debt instruments. Moreover, the U.S courts also failed to consider this serious breach of pari passu clause, while promoting the so called judge mediated restructuring .
Argentina should be encouraged to negotiate with these creditors so that Argentina debt restructuring can not be taken as an example by the other countries to easily evade their financial obligations by resorting to restructuring, which would not only negatively affect the development of these countries but also the global financial system. This has become more important in view if the robust economic performance of Argentina in the years just preceding the conclusion of the restructuring. According to Gullemo Nielson, Secretary Finanzas “Argentina grew by 8.8% in 2004 and 2003, one of the two or three countries with highest growth in the last two of three years and has almost recovered from all of grounds lost in terms of GDP between 1998 and 2002” (Speech delivered at Global Market Research Seminar, Argentina on 4 March 2005), which demonstrates the unwillingness rather than inability to meet its financial obligations.

Bibliography and References

1. G.Mitu Gulati and Kenneth N.Lee, Sovereign Piracy, 56 Bus. Law. 635 (2000-2001)
2. Lee C. Buccheit & Jeremiah S Pam, The Pari Passu Clause in Sovereign Debt Instruments, 53 Emory L. J. 869 (2004)
3. Jose Garcia-Hamilton Jr., Rodrigo Olivaris-Caminal & Octaviom M. Zenarruza, The Required Threshold to Restructure Sovereign Debt, 27 Loy. L.A. Int’l & Comp. L. Rev. 254 (2005)
4. Philip R Wood, Pari Passu Clause-What do they mean?, 10 JIBFL 372 (2003)
5. Robert J. Shapiro and Nam D. Pham, Discredited – The Impact of Argentina’s Sovereign Debt Default and Debt Restructuring on U.S. Taxpayers and Investors available at ,
6. Anna Gelpern, After Argentina, Policy briefs in International economics, Pg. 1 www.iie.com/publications/pb/pb05-2.pdf
7. Marcus Miller and Dania Thomas, Sovereign Debt Restructuring: The Judge the vulture and creditor rights 202/06, April 2006, available at
8. Issue 79 Pari Passu Clause, Financial Markets Law Committee March 2005 available at , Last visited 30.12.2007
9. International Monetary Fund Policy on Lending into Arrears to Private Creditors—Further Consideration of the Good Faith Criterion available at:
10. Position paper: “Most favored creditor clause, Global committee of Argentine bondholders available at < www.gcab.org/images/GCAB_Position_Paper_-_MFC_Clause_-_1-31-05.pdf >
11. Smitha Francis, “Argetina Debt Swap-One Step forward and miles to go” available at
12. Dr. Rodrigo Olivares-Caminal, ‘De Holdouts y Otros Demonios’, Suplement Especial La Ley ‘El Canje de la Deuda’, May 2005, Buenos Aires, Argentina
13. Speech of the Gullemo Nielson, Secretaria de finanzas, Ministrio de Economia y Produccion, 4 March 2005 available at:
14. Elliot Associates v The Republic of Peru, 96 Civ. 7916 (RWS)
15. E.M Ltd and NML Capitals Ltd v Republic Of Argentina, Docket Nos. 06-0403-cv, 06-0405-cv, 06-0406-cv 46 131 Fed. Appx 745; 2005 U.S. App. LEXIS 8599
16. Supplement (to Prospectus dated 27 December 2004) of the Republic of Argentina exchange offer to exchange eligible securities for Par Bonds due 2038, Discount Bonds due December 2033, Quasi-Par Bonds due December 2045 and GDP-linked Securities that expire in December 2035
17. Republic of Argentina v Weltover, 504 U.S. 607,112 S. Ct.2160
18.
19. < www.reuters.com/article/politicsNews/idUSN0240452720071002>