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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
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19. < www.reuters.com/article/politicsNews/idUSN0240452720071002>
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