On February 27th the Second Circuit Court of Appeals heard oral arguments between plaintiff-appellees, hedge funds NML and Aurelius, and appellants led by the Republic of Argentina (Argentina). Argentina is joined by Bank of New York Mellon (BNY Mellon), the Exchange Bondholders Group, and Fintech Advisory. The appellant’s are challenging the November 21st ruling by District Court Judge Griesa of the Southern District of New York that ordered Argentina to pay principal and interest owed to defaulted creditors (NML and Aurelius) as well as prohibited BNY Mellon from facilitating Argentina’s interest payments to its current bondholders without also paying the defaulted creditors.
The path to economic purgatory
Argentina was on the verge of economic collapse in the late 1990s and early 2000s. By the time the new millennium approached the nation was gripped by violent riots, a sky-high unemployment rate and a vicious cycle of battling debt with debt. In 2001, Argentina ceased paying principal and interest to its bondholders and defaulted on $100 billion of debt. In 2005 and again in 2010, Argentina offered the holders of its defaulted debt “exchange bonds” on new terms (around 30 cents on the dollar). About 93% of bondholders agreed to cut their losses and accept the exchange bonds. The 7% that have held-out, aptly referred to as “the holdouts”, have brought over a decade of litigation against Argentina claiming payment on their original bonds. The holdouts are led by hedge funds Elliot Management (the parent fund of NML Capital) and Aurelius Capital Management. Their argument is simple; they never took the exchange offer so Argentina still owes them the full principal and interest that they are contractually entitled to, which is now between $1.3-1.6 billion.
When Argentina began its economic slide in early 2000 most investors took what was left of their capital and ran in the opposite direction. As always, there is someone willing to run toward the fire. In the case of distressed investing “the few and the proud” are funds that specialize in distressed opportunities. Some see distressed debt investors as “vultures” that pick apart struggling debtors, others believe they are a necessary market force that hold debtors accountable. For the funds, the bet is that the underlying distressed asset will return to profitability or, in this case, that with the right legal maneuvering they will get judgment for full principal and interest.
Why has it taken ten years to settle the dispute?
Argentina is a sovereign nation and unlike a corporation, the creditors in a sovereign default can’t simply force the entity into bankruptcy to restructure or liquidate the assets. Instead the holdouts have brought dozens of actions from a variety of angles against Argentina, all with the single goal of seeking to collect on the defaulted debt.
Despite several judgments in favor of the holdouts, Argentina has refused to pay. Argentina argues that any payment would be a violation of its own laws as well as the Foreign Sovereign Immunities Act (FSIA). The challenge is that the holdouts must find property within the jurisdiction of the court to be able to attach it in execution of the debt. Most sovereign nations have very few assets located in foreign jurisdictions and most of those assets are generally protected. For example, the assets of a central bank located abroad are generally exempt from attachment. A court may however attach or execute upon property that the sovereign “used for commercial activity in the United States.” 28 USC §1610(a). The holdouts have pursued a lengthy discovery, serving subpoenas on American, European and Argentinian banks in an attempt to understand Argentina’s ‘financial circulatory system.’ 695 F.3d 201 (2012). Understanding and tracking Argentina’s financial network is the first step in determining the places and times when those assets might be subject to attachment and execution and additionally if they were used for what is classified as “commercial activity”.
In March 2012 the Second Circuit Court of Appeals upheld a 2010 judgment by Judge Griesa for the attachment of funds held in a New York bank account and owned by the Argentine Ministry of Science, Technology, and Productive Innovation. 680 F.3d 254. The court found that it was appropriate to seize the account which contained a little over $3 million because it was used by the Ministry to purchase equipment in a private manner and because the Ministry was an instrument of Argentina. With judgments and appeals spanning 4 years to win attachment of a $3 million account it’s not hard to see what a painstaking process the holdout creditors must pursue to claim the full $1.6 billion.
The holdouts have additionally pursued an alternative course of action, seeking to prohibit Argentina from paying its existing bondholders of the 2005 and 2010 exchange bonds unless they additionally pay the holdouts. The hope is that Argentina will be more willing to settle when the alternative is repeated default. The holdouts are arguing for enforcement of a provision in the original bonds issued by Argentina that states, “the Securities will constitute…direct, unconditional, unsecured and unsubordinated obligation of the Republic and shall at all times rank pari passu”. The holdouts believe that this pari passu (equal step) provision means Argentina is unable to pay holders of its exchange bonds without concurrently paying the original bondholders.
In his November 21st ruling, Judge Griesa agreed and ordered Argentina to pay the $1.3 billion in principal and interest owed to the holdout creditors. Judge Griesa held that when Argentina makes any payment to the bondholders of its 2005 and 2010 exchange debt it must also concurrently make payment to its original holdout bondholders. Additionally, Judge Griesa also bound all ancillary parties to the court order. This means that any move by the Depository Trust Company (DTC), Euroclear or BNY Mellon (acting as indenture trustees or clearing and transfer agents) to continue to keep Argentina current on its payment to those exchange bondholders without also paying the holdouts, would be seen as “aiding or abetting” Argentina in violation of the court’s order.
Implications for Argentina and the sovereign debt market
Not surprisingly the case has major implications for the ability of Argentina to function financially and politically. Over ten years after default, the financial outlook for Argentina is still challenging and undoubtedly hampered by the ongoing uncertainty surrounding this litigation. News of Judge Griesa’s ruling caused Fitch to cut Argentina’s credit rating after reviewing the outlook and probability of repeated default. A lower credit rating means a higher cost of capital for the nation and more of every dollar raised must be diverted to service outstanding debt rather than going to cover the cost of needed goods and services.
The litigation is having a very real and embarrassing impact on Argentina’s political leaders as well. In a recent international trip President Cristina Kirchner had to charter a private jet fearing that the official state airplane would be seized. The charter came at a 20% premium to what the trip would have cost on the government aircraft. President Kirchner was probably right to be paranoid given the situation that unfolded last fall when a Ghana court ruled in favor of NML who sought $20 million for the release of an Argentine naval ship that was docked in the countries port of Tema. A United Nations court eventually ordered the ships release.
The case will carry implications for future issuers and investors in the sovereign debt market. The year that Argentina defaulted was the same year that the International Monetary Fund (IMF) created a proposal for a new legal institutional framework “the sovereign debt restructuring mechanism” for resolving these types of debt crisis. Although the proposal fell through, it did encourage further use of collective action clauses, now the law in European issuances. Collective action clauses allow for restructuring agreements that are agreed to by a supermajority of bondholders to be binding upon all. Although they are growing in use and could have helped to avoid some of the situation that has unfolded with Argentina (where 93% of bondholders agreed to the exchange offer), they have their own complications, especially with risky emerging market issuers who are often in need of (and therefore, at the will of) any willing and able investor.
Why today and what will tomorrow hold?
While there is nothing novel about a small or emerging nation reneging on its financial promises there have been several major shifts in international financial markets over the last thirty years that have led to the current situation. A narrowing construction of the concept of sovereign immunity, growth in securitization and the secondary market for sovereign debt, and creditor success in litigation have each contributed to the current situation for Argentina and its creditors. Absent broad IMF reform or tighter indenture agreements there is good reason to believe we will see similar cases in the future.
Traditionally, nations enjoyed the protection of absolute sovereign immunity. Today, the reality is a much more limited form of sovereign protection. The seeds of this change were planted over 360 years ago when the radical English lawyer John Cooke put King Charles I on trial in 1649 for crimes against the state. Along with costing both men their lives, the case illustrated that even the King was not above the law and destroyed many of the previously unchallenged concepts on sovereign immunity. More recently the Foreign Sovereign Immunities Act of 1976 created a more restrictive interpretation of sovereign immunity and it greatly increased the power of private parties seeking to attach the commercial activity of sovereigns being carried on within the United States. The U.K. and many other jurisdictions have passed similar legislation since.
The emergence of a secondary market for sovereign debt over the past thirty years has also played a pivotal role in forcing the hand of many emerging sovereign debtors. Before the late 1980s holders of sovereign debt were traditional banks that lent to emerging nations in the form of syndicated loans. Instead of pursuing litigation against the nations (which would have required the banks to have sufficient loan-loss reserves to declare the countries in default and write down the losses) they simply renegotiated the terms of the loans and kicked the can further down the road. By the late 1980s these banks dramatically increased their loan-loss reserves in anticipation of having to write-off significant portions of their emerging market portfolios. Banks began to securitize these loans and structure them as bonds that they sold on the secondary market to other banks, investors and specialty distressed debt funds that were emerging to take their chances on repayment.
Similar distressed creditor suits have unfolded involving Costa Rica in the 1980s and Brazil and Peru in the 1990s. As funds experience success in being able to extract payment through litigation, copycats will inevitably follow. However, there is reason to believe that when Argentina defaulted in 2001, the prospect of recovery may have seemed a bit brighter to Elliot and others. In June 2000 Elliot received a judgment against Peru for full repayment of debt (around $60 million) that Elliot bought up at a steep discount (around $20 million) amid the country’s economic downturn in the late 1990s. Elliot was able to convince a Brussels appeals court to order Euroclear to suspend its current bond interest payments until Elliot received full payment. Peru ended up settling for $56 million rather than continue to fight and miss its current interest payments putting its outstanding debt once again into default. The argument that Elliot wielded was not surprisingly centered on the same pari passu provision that it has attempted to enforce against Argentina. The interpretation by the Brussels court is controversial and has been challenged in the context of the current case. Pari passu if read more precisely means that the debt obligations must be paid concurrently without a preference for one over the other. Some believe that by ordering Euroclear to suspend further payments on the other obligations until the debt held by Elliot was paid in full, the court was not treating the debt equally but actually preferentially.
Nevertheless, all signs point to a difficult road ahead for emerging market sovereign issuers like Argentina, Peru and even the non-emerging but unstable economies of Greece and others. Recent history has shown that the pace at which nations are re-accessing capital markets after default has quickened. The upside is that they are able to access much needed capital at critical times. The downside is that they are most likely attempting to negotiate with creditors in their weakest moments. As long as this is the case, these unstable nations will continue to agree to costly terms for their immediate capital needs to the detriment of their younger and future citizens. In their defense, these governments might argue that there is little alternative and they are unable to delay in meeting the pressing needs of their people, echoing the words of New Deal architect Harry Hopkins when he remarked, “people don’t eat in the long run, they eat every day.”