A US ruling against Argentina could switch initiative in bond markets back to creditors
When Cipriano Castro, a fearsomely mustachioed strongman from the Andes, seized power in Venezuela in 1899 and defaulted on the government’s foreign debts, the jilted European powers knew how to react: they sent the warships, which bombarded and blockaded the country until a settlement was reached.
The enforcement of creditor rights in sovereign debt restructurings has since become less violent. Gunboats gradually became an unacceptable way of collecting debts. For much of the past century, governments have largely been able to renege on their debts with a degree of impunity, albeit not without some pain.
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Yet a decision last week by a New York court could swing the pendulum back towards creditors. Although the case may still end up in the US Supreme Court, the ruling potentially erodes the ability of countries to spurn creditors – and could embolden those hedge funds, known as vultures, that specialise in suing recalcitrant governments.
The case in question is a long-running legal battle between
Argentina and several so-called vulture fundsthat refused to join the 93 per cent of creditors that agreed to the punitive restructuring that followed the country’s 2001 default. The US courts have ruled unexpectedly harshly against Argentina, rattling markets and throwing money managers, lawyers and analysts into a spasm of speculation.
“This has the potential to break the paradigm of the sovereign debt world,” says Hans Humes of Greylock Capital Management, a fund that specialises in emerging markets. Mr Humes co-chaired the committee of Argentina’s bondholders and sat on Greece’s creditor committee during its restructuring this year.
“Creditor rights have been methodically stripped away in recent years, but this may bring us back,” he says.
Elliott Associates, the main hedge fund plaintiff, is run by Paul Singer, the US billionaire, and has made extracting money from defaulting governments its calling card. Elliott
won the Argentine case through an arguably novel interpretation of a Latin phrase:
pari passu. It means “on equal footing” or “in equal step” and is a venerable legal clause in bonds and loans.
In corporate bankruptcies, pari passu creditors rank equally in the queue when companies are dissolved, the assets are sold and proceeds disbursed to lenders. Although countries do not go into bankruptcy, the clause has long featured in government bonds and loans even though lawyers disagree on the clause’s meaning and importance, says Mitu Gulati, a law professor at Duke University and former lawyer at Cleary Gottlieb, Argentina’s counsel.
Elliott and Aurelius Capital, its co-plaintiff, founded by a former Elliott trader, successfully argued that the pari passu clause in their defaulted bonds meant that Argentina could not continue to ignore them while paying the holders of its restructured debt.
But District Court Judge Thomas Griesa went further than just finding in favour of the hedge funds. Lawyers say he broke new ground in how widely the clause can be interpreted, and how far creditors can go in seeking redress from defaulting countries.
Lenders can win legal cases against countries, but winning compensation is trickier. Most overseas government assets are protected by sovereign immunity. Vultures typically try to create such legal bother that countries eventually pay them to go away.
But this so-called holdout strategy depends on extreme patience and deep pockets. Argentina, for example, has largely been able to thumb its nose at creditors for almost a decade. Elliott has proved a dogged adversary and even
seized an Argentine navy training ship in October after it docked in Ghana. But despite this forceful demonstration of willpower, Elliot has so far failed to extract a single peso from Buenos Aires.
By contrast, Judge Griesa has backed up the bark of his ruling with a sharp bite that may bolster the hedge funds in their showdown with Argentina. The injunction prohibited third parties from “aiding and abetting” any violation of his order.
This was primarily aimed at
Bank of New York Mellon, the conduit of Argentina’s payments to the holders of its restructured debts. Unless the appeals court intervenes, Argentina must pay Elliott and the other plaintiffs more than $1.3bn by December 15, BNY Mellon will breach the injunction if it transfers regular payments to Argentina’s lenders due on the same date.
BNY Mellon is unlikely to defy the court, so this essentially means that unless Argentina pays the vulture funds it could default on its international debts once more. Lawyers say that Judge Griesa’s legal dragnet leaves little room for escape, though Argentina and holders of restructured bonds have filed emergency appeals. It also applies to parties in the payments system – the economy’s circulatory system – including overseas clearing houses such as Euroclear.
This has far-reaching implications, says Anna Gelpern, a law professor at American University and Georgetown, previously of the US Treasury and Cleary Gottlieb.
“Grabbing a ship in Ghana is serious, but still a serious nuisance. In contrast, the ability of holdouts to seize money in the payments system is of systemic importance,” Ms Gelpern says. “Gunboats could target individual countries but targeting the payments system is an entirely different kettle of fish.”
In a similar case in 2004, the New York Federal Reserve argued that the vulture funds’ methods represented “terrorism of payments and settlement systems”. Euroclear says it is monitoring the case “closely” but does “not intend to breach this US court order”.
Argentina’s restructured bondholders have reacted with fury, and have hired David Boies, the celebrated litigator who represented Al Gore in the Supreme Court case that decided the 2000 presidential election. In an odd twist, Elliott’s lawyer is Ted Olson, the former US solicitor general who represented George W. Bush.
In the motion to avert the injunction, the bondholders’ lawyers attacked Judge Griesa’s “level of rancour” against Argentina and argued that it could damage foreign relations.
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Other powerful actors could also intervene. Whitney Debevoise, a partner at Arnold & Porter and the former US executive director of the World Bank, argues that the court’s interpretation of pari passu could lead to challenges of the protected status multinational organisations such as the World Bank and the International Monetary Fund enjoy in debt restructurings.
This “seniority” is a longstanding custom that has never been tested. Indeed, even Elliott stated that “commercial creditors never were nor could be on equal footing with the multinational organisations”.
Thomas Laryea, a partner at SNR Denton, the law firm, and former assistant general counsel at the IMF, argues that the official sector’s protection is unharmed by the pari passu argument, and says “the court did a job of avoiding a hot potato”.
Despite the
uproar the court case has already caused, many experts caution that the impact could still prove to be limited outside legal academia. They point out several factors that limit its usefulness as a precedent.
The wording of pari passu clauses vary from contract to contract. Argentina’s bonds implied a promise of equal payment, not just equal ranking. This was clearly violated by Argentina’s so-called lock law that in effect prohibits payments to holdouts. Although the courts did not base their rulings on the law, it made a breach much more obvious. Lawyers say other pari passu clause cases may be harder to argue.
Argentina’s obstinacy also makes it an outlier in the history of sovereign restructurings. Most countries quickly – or eventually – pay off holdouts, and restructurings go relatively smoothly despite the presence of vultures, says Charles Blitzer, a former IMF official. Greece, for example, restructured its larger local debts but has chosen to pay international law bonds in full to avoid costly and destabilising suits.
Argentina, on the other hand, boasts a
debt museum in Buenos Aires that charts its chequered history of defaults and a board game called Eternal Debt in which players are asked: “Can you beat the IMF?”
The US courts have also argued that the broad interpretation of pari passu will not thwart future sovereign restructurings, pointing out that since 2005 the vast majority of New York law bonds have included collective action clauses. These allow a certain majority of bondholders to force holdouts to sign up to an agreed settlement.
Most of all, the Argentine saga has further to run. The appeals court still has to approve whether third parties and bondholders’ payments can be forcibly enlisted by Judge Griesa to put pressure on Argentina.
Argentina has vowed to appeal all the way to the US Supreme Court if necessary. The highest court normally does not hear contract interpretation cases of this kind but could do so if it thinks the ruling could have a systemic impact on the payments system and the international bond market.
Most sovereign law and restructuring experts agree that the case will inevitably have repercussions.
Collective action clauses, for example, are no panacea because they largely apply only to individual bonds, not a country’s overall debt burden. Hedge funds can still play holdout by gaining a blocking minority in one bond, making a restructuring of that instrument impossible.
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Anne Krueger, a former senior official at the IMF and chief economist at the World Bank, now a professor of economics at Johns Hopkins University, argues that the case “clearly represents an erosion of sovereign immunity” that will embolden vulture funds in the future.
“Unless the Griesa ruling is overturned, this will open up a can of worms that will have to be dealt with,” she warns. “I don’t think it will be a revolution, as enough people have an interest in preserving the status quo. But it will have an impact.”
This may not necessarily be a negative development. Countries will still hold most of the aces in restructurings. The IMF has tallied more than 600 sovereign restructurings in 95 countries between 1950 and 2010. Giving creditors at least one trump to play may on the margins encourage better behaviour.
Any government concerned by the case’s implications can modify or remove the pari passu clauses in future bonds or avoid the New York jurisdiction altogether – perhaps in favour of London, where courts could choose to disregard the US precedent.
A side-effect may be to encourage vulture funds. But in spite of the opprobrium being heaped on these investors, experts for the most part agree that the problems they cause are outweighed by the benefits they bring: Funds such as Elliott are the “bad cops” of sovereign bond markets. The threat of legal battles makes defaults less attractive and encourages countries to treat creditors slightly better when they do have to restructure.
“I wonder why other sovereigns don’t gang up on Argentina and say, ‘for God’s sake stop this, you’re ruining it for all of us,” says one experienced sovereign restructuring expert. “I’ve been doing sovereign restructurings for 30 years and countries have generally had it good. That could change now.
