During the 1990s, Argentina was the darling of international investors, so much so that it accumulated a debt of more than $100 billion. In 2001, an economic crisis hit Argentina, and the country was forced to default on its external debt. Four years of negotiations passed until Argentina finally imposed a drastic restructuring, which was carried out in 2005 and 2010. Only 30 cents per dollar of the original debt was offered to private holders. Eventually, 92 percent of bondholders, colloquially known as the “holdins”, accepted this agreement, but 8 percent—the “holdouts”—refused the offer. Several of these holdouts had bonds were under U.S. jurisdiction, including NML Capital—a subsidiary of American businessman Paul Singer’s Elliot Management—and they jointly filed a lawsuit against Argentina. Their litigation was successful. In a controversial ruling this year, federal Judge Thomas Griesa prohibited the Bank of New York from transferring payments from Argentina to the holdins until the dispute is settled. The result: Argentina is in default for the second time in 13 years.
Griesa’s ruling sets a worrisome precedent for sovereign nations trying to restructure debt. Right now, the American legal system and the “vulture funds”—including NML capital and others in the business of distressed securities—are sending a disturbing message to international creditors: if you fight hard enough, spend enough money on lawyers, and have enough patience, you will ultimately get your original deal. The campaign led by NML has been relentless, and it may very well be profitable in the end. The prospect of such a reward might entice additional creditors to reject restructuring plans. This could result in lower participation in these deals, which would ultimately undermine a country’s ability to overcome a default. Furthermore, it is disturbing that it is within the limits of the law for a group of private individuals to potentially coerce a country. The American legal system should recognize the broader implications of empowering holdouts and trespassing on sovereignty. The arrangement of sovereign debt should be reformed to allow for accountability and efficiency; lawsuits and more bankruptcy are not responsible ways to handle this issue.
The real problem with public debt
A restructuring is the country equivalent of liquidating a bankrupt company. When a company goes bankrupt, all its assets are sold, and the proceeds are distributed amongst creditors. Unfortunately, sometimes there isn’t enough to repay investors fully—this is part of the risk of any investment. In a conversation with HPR, Guido Sandleris, Dean of the University of Torcuato Di Tella Business School, argues that the biggest issue at stake is that “country debt is different from private debt.” Firstly, countries cannot cease to operate, so when they restructure they cannot sell all their assets; instead, they should pay as much as they can. Secondly, creditors are not obligated to accept the new terms in a sovereign restructuring. This is where the “holdout” problem comes in. Paul Singer justifies his actions by arguing that it is only right that Argentina returns what it borrowed. This may be true, but he holds defaulted bonds; the risk of default always existed, and Singer acknowledged it when he accepted Argentina’s high bond interest payments.
Finally, while a company’s assets are appropriable by the local judicial system, how does one appropriate a country’s assets without trespassing sovereign bounds? Singer argues that his actions hold countries accountable and force them to lend within their means. However, lending could be disciplined with regulation instead. Moreover, the international community has recently made moves to reform sovereign debt contracts. Sandleris agrees that “the absence of established mechanisms for the restructuring of sovereign debt makes the process [of debt negotiations], sometimes, quite chaotic.” Until now, the system worked when there was trust and goodwill on both the private and the public sides of debt contracts. However, in the case of Argentina, this rapport has been broken. If we expect sovereigns to continue participating in the international capital market, either trust must be recovered or the system must undergo serious reform.
A bizarre love triangle: vulture funds, Judge Griesa, and Argentina
Argentina is a good case study to show these vulture funds’ persistence and effectiveness, and how easy and sometimes inevitable it is for a country to make a mistake in contracts with such groups. Argentina breached the pari passu clause—an obscure clause included in sovereign debt contracts as a matter of course—by legally subverting holdout claims through its “lock law”, which was ratified in 2005 and prevents the government from offering the 2005 exchange terms to those who did not opt in at the time. Argentina also did not include collective action clauses in its borrowing terms; under such clauses, if a majority of bondholders accepts the terms of restructuring, everyone must do so. Further, the Rights Upon Future Offers (RUFO) clause of the contracts stated that if Argentina voluntarily offers better terms to any bondholder, it must offer better terms to everyone, which would deplete its foreign reserves. Thus, it cannot negotiate with the vulture funds until this clause expires in December 2014.
Judge Griesa’s ruling is understandable within the specific legal context of the case, but not in the bigger picture. Narrowly speaking, his interpretation of the pari passu clause can be defended. However, Griesa could have sustained the current law without bringing Argentina to a second default. He could have determined a different remedy that resulted in Argentina paying less than the full $1.3 billion, or he could have sentenced a stay until December when the RUFO clause expires and Argentina will be at least able to negotiate with the holdouts. In a conversation with HPR, Lucas Llach, an economics professor at the University of Torcuato Di Tella, explains, “If judges reward those who do not accept restructuring deals and ask for the totality of payments, these deals, when faced with bankruptcy, will be impossible.”
However, Argentina’s continuous challenges to Griesa’s authority may have frustrated the judge beyond reason. Besides missing meetings, appealing all his decisions, and taking the case to the U.S. Supreme Court, the United Nations, and the International Criminal Court, Argentina has also offered to exchange bonds under U.S. jurisdiction to Argentine jurisdiction, a blatant attempt to undermine Griesa’s authority. However, as Llach articulated, “Despite the fact that it is a subject with important consequences for the international financial system, none of the important regulators of this system have participated in the process. Everything was left in the hands of the American justice system, which doesn’t necessarily take into account the impact of this decision on international debt markets.” Today the losers are the holdins who have yet to receive their blocked payments; tomorrow the losers could be sovereigns who decide to finance themselves in other ways, or the U.S. financial centers that lose business when countries begin to issue debt elsewhere.
If creditors have reason to believe that defaulted sovereigns can pay them back the full amount of their bonds, then it is unlikely that they will accept a restructuring. The vulture funds are giving them that reason. This is not the first time that Elliot Management and NML Capital have profited off distressed securities; they actually specialize in it. For example, when they took control of a GM and Chrysler parts supplier in 2009, the U.S. government called their practices extortion. In 2000, Peru settled with them for $58 million after a Brussels court threatened to block payments to other bondholders. In this last transaction, Elliot Management reported a 400 percent profit. Although the firm has employed a different strategy with each case, its success could lead investors to reject future restructuring and wait for larger profits. However, this is unsustainable. A country defaults when it cannot pay 100 percent of creditors the full value of their bonds. As the group of holdouts gets bigger, it will become impossible for a country to repay all of them, making it harder to overcome a default. Argentina has the money to pay the litigating holdouts the $1.3 billion claimed, but paying 100 percent of creditors the original terms of their bonds would deplete its foreign reserves.
The Question of Sovereignty
Another reason countries might shy away from issuing debt altogether is because it seems to justify breaching the limits of sovereignty. In the case against Argentina, the vulture funds have attempted to embargo what they can; their most notorious success occurred when a Ghanaian court blocked an Argentine navy vessel from leaving their port. Ultimately, their greatest victory has been Judge Griesa’s ruling: he ordered Argentina pay the litigators the original terms of their bonds as a remedy for breaching the pari passu clause. Until these terms are fulfilled, he has blocked the transfer of Argentine public funds through American banks.
The United States government has the right to overrule the justice system if it interferes with the president’s ability to run foreign policy. President Bush invoked this power to stop Elliot Management from seizing the Republic of Congo’s property in the United States. The Obama administration has yet to clarify why it hasn’t stepped in. A possible explanation is that Argentina has also antagonized the U.S. government in several ways, including its friendly relations with Venezuela and its deal with Iran to try to resolve a terrorist attack from 1994. Notwithstanding, the U.S. government has an interest in preventing the vulture funds from proceeding. Firstly, there are self-interested reasons: countries could begin to issue debt under different jurisdictions for fear of the American legal system, thus the United States would lose its place as an eminent financial center. Secondly, there are the right reasons: if the United States believes in the current world order, it should defend the principles of sovereignty upon which it stands.
We live in a society where citizens make money within legal limits. The state is in place to make sure that these laws only allow legitimate activities. The United Kingdom, for example, has enacted legislation limiting the profit available to those who buy debt on the secondary market. The United Nations has also recognized the need to protect sovereign nations from these financial speculators. Singer is playing by the rules, but the U.S. government is failing to see that these rules should be changed. It is only a matter of time before more firms realize how profitable it is to be a holdout. Ultimately, the actions of Singer, Griesa, and the U.S. government have served Argentina justice on their own terms, but they have potentially undermined any state’s capacity to restructure debt for years to come.
Image source: The Economist