In a special online essay, UNCTAD reiterates its long-standing call for a sovereign debt workout mechanism.
Global and systemic implications of United States Supreme Court rulings in favour of hedge funds over Argentina on 2001 defaulted bonds
The United States Supreme Court issued a ruling on 16 June 2014 declining to hear Argentina's appeal against a lower New York court decision that had ordered it to pay suing hedge funds $1.33 billion, which is principal plus interest for holdout bonds. This was followed shortly by another decision by the Supreme Court to order the relevant financial institutions of the United States of America to turn over information to these hedge funds about assets that Argentina holds worldwide, including accounts held by entities of the Government of Argentina and by individual officials1.
These two rulings targeted at Argentina's 2005 and 2010 debt swaps, in the wake of its catastrophic 2001-2002 default on $100 billion bonds governed by New York law, resonate well beyond the borders of Argentina and the United States. The rulings are a resounding victory for the specific hedge funds that have held out on Argentine debt swaps. They also open the door for other "vulture" funds and holdout investors to come forward to request full payment on Argentine bonds, estimated at around $15 billion. If Argentina pays the holdout bond holders, it must extend full payment to the bond holders that accepted the 2005 or 2010 debt swaps, due to a "Rights upon Future Offers" clause in its law. This would amount to an estimated cost of over US$120 billion2. In fact, the rulings could open floodgates to other similar cases depending on interpretations given by courts under New York law, British law or other laws. Copycats will abound.
But they also set legal precedents which could have profound consequences for the international financial system:
First, by removing financial incentives for creditors to participate in orderly debt workouts, the rulings will make future debt restructuring even more difficult, in particular for outstanding bonds without a Collective Action Clause, the actual amount of which is unknown but is likely to be large.
Second, obligating third-party financial institutions to provide information about assets of sovereign borrowers will have a significant impact on the international financial system as it forces financial service institutions to provide confidential information on the sovereign borrower's global financial transactions to facilitate the enforcement of debt contracts for the creditors.
Third, the ruling will erode sovereign immunity.
A setback for debt restructuring
After defaulting on its $100 billion sovereign bonds in 2001, Argentina offered debt swaps in 2005 and in 2010. Investors holding about 93 per cent of the old bonds participated in these debt swaps. The Congress of Argentina passed a law in February 2005 that forbade the Government to make payments on any bonds not tendered, to later reopen the exchange or to settle with non-participating creditors one by one on the side. However, a handful of hedge funds purchased the bonds after the default when they were at deep discounts. Since then, they have repeatedly demanded to be paid at 100 per cent of their face value. This is considered by many as predatory. For example, NML Capital purchased the majority of their Argentine bonds from June-November 2008, paying an estimated $48.7 million for over $220 million in defaulted bonds, a price of just over 20 cents on the dollar3.
According to estimates by Morgan Stanley, bond holders who accepted the 2005 offer have received returns of about 90 per cent4 thanks in particular to a coupon linked to gross domestic product growth, which significantly increased the amount actually received. In response, the holdout bond holders led by NML Captial changed tactics and took out law suits (based on the pari passu, or equal treatment, clause in bond contracts) in New York's lower court which would tie any future payments on restructured bonds to payment in full to holdout bond holders This was an unheard of interpretation of the clause which shocked even veterans in the debt restructuring world. However, on 18 November 2013, the United States Second Circuit Court of Appeals ruled in favour of NML Capital. Argentina appealed the ruling to the United States Supreme Court. With the Supreme Court leaving the lower court rulings intact, it has created a precedent for awarding holdout creditors and penalizing creditors who participated in a debt restructuring.
Since the Argentine default, there has been a more prevalent introduction of the Collective Action Clause in bond contracts which has the potential of restricting the likelihood of a small number of creditors holding out on debt restructuring. However, it is important to note that existing bonds without Collective Action Clause will take years to expire. This means that, with the Supreme Court rulings, the world has limited tools to initiate debt restructuring for bonds with a pari passu clause and without Collective Action Clause. The Supreme Court ruling has given bond holders a strong weapon to get full payments. As stated in the recently published International Monetary Fund (IMF) paper on debt restructuring, "in essence, the [United States] courts have interpreted a 'boiler plate provision' of these contracts (the pari passu clause) as requiring a sovereign debtor to make full payment on a defaulted claim (in this case, held by the secondary market purchaser) if it makes any payments on the restructured bonds"5.
Given such consequences, the Governments of France and Germany supported Argentina in its legal struggle. Economists such as Joseph Stiglitz and Anne Kruger petitioned against the hedge funds.
Obliging financial institutions to assist debt collectors
The Second Circuit also rules that third parties (banks in this case) who make payments on behalf of the Government of Argentina to bond holders which participated in the two debt swaps will be punished and viewed and treated as being in contempt of law if they continue to make such payments and holdouts are paid in full. On top of this, the second ruling of the Supreme Court confirmed NML Capital's request that banks involved in handling the payment of Argentine bond holders must turn over information to holdout bond holders on assets that Argentina holds worldwide. Obliging financial institutions to provide information about assets of sovereign borrowers' assets worldwide will have significant impact on the international financial system as it forces financial service providers to provide confidential information on the sovereign borrower's global financial transactions to facilitate enforcement of debt contracts on behalf of the creditors. Third parties have been dragged from the wings to centre stage. In addition, it also seems they are obliged to assist holdout bond holders in reclaiming their debt. Once again, exchange holders are punished and holdouts are rewarded.
Justice Ruth Bader Ginsburg, a member in the Supreme Court's group of justices deciding the case, asked: "By what authorization does a court in the United States become a 'clearinghouse for information' about any and all property held by Argentina abroad?6" By setting this legal precedent, it would not be surprising to see changes in the financial market and ways to aid creditors in enforcing contracts and punishing borrowers.
Erosion of sovereign immunity
The ruling does not only impact the financial service providers involved, it also severely erodes sovereign immunity and is not in compliance with the United States Foreign Sovereign Immunities Act. The Government of the United States filed a brief in favour of Argentina and stated that a ruling in favour of bond holders would harm international relations and could provoke "reciprocal adverse treatment of the United States in foreign courts"7. An official representing the Administration cautioned at the Court that "the United States would be gravely concerned about an order of a trial court in a foreign country, entered at the behest of a private person, seeking to establish a clearinghouse in that country of all the United States' assets"8. However, the Chief Justice of the United States Supreme Court did not seem to feel any apprehension. In response to concern of the Government of the United States on non-compliance with the Immunities Act, the Justice advised the Government to amend the Act.
With the Supreme Court ruling, the likelihood of aggressive holdout investors snatching assets of defaulted sovereigns might increase. In 2012, NML Capital detained an Argentine navy vessel in Ghana as part of its effort to gain repayment on the defaulted securities.
Following an Argentine proposal to pay exchange bond holders in Argentina under Argentine law on 17 June, one day after the Supreme Court rulings, the United States Second Circuit Court of Appeals ruled that this kind of act is in violation of the rulings and proceedings now in place in the Southern District of New York.
Restating the case for a sovereign debt workout mechanism
The United States Supreme Court rulings have once again demonstrated what can happen in the absence of an international debt workout mechanism. This vacuum has led to fragmentation of legal forums, thereby creating inconsistency and unpredictability. Different courts have very different interpretations of the same contractual clause and can impose a wide array of rulings. Politics and interests groups can impact on the outcome of rulings and debt restructurings, compromising consistency and fairness.
The rulings have made future debt restructuring much more difficult as debtors are left with only moral suasion and foreign relations as weapons to encourage creditor coordination. They have also strengthened the hand of creditors even though their behaviour can be among the underlying causes of debt crises.
The June 2014 IMF Policy Paper entitled "The Fund's lending framework and sovereign debt - preliminary considerations" and its annexes (in a separate paper) reviewed the lessons of past debt restructurings. However, when it comes to possible directions for reform, the proposals are to maintain a market-based approach (based on debt contracts) and debt reprofiling - extending debt maturity - based on the IMF's judgement that an unsustainable debt situation exists. Debt reprofiling has the potential to trigger credit default swaps and is viewed by some as a debt restructuring. One wonders whether the IMF is best positioned to give timely and fair judgements and how unsustainable debt could eventually be restructured when the world does not possess sufficient tools to deal with the problems encountered so far. To rely on the market approach under which different courts are to interpret clauses of the debt contracts as the United States Supreme Court has done would lead to outcomes with "broad systemic implications", just as the IMF warned.
In this chaotic context, the formulation of global and harmonious rules and principles guiding sovereign debt restructurings has become of paramount importance. This is why UNCTAD has been a long-standing advocate of a sovereign debt workout mechanism and is currently working on a project financed by the Government of Norway to further clarify how it could work in practice. The list of general principles and issues identified thus far by a group of experts under the project includes:
- Standstill/stay of litigation
- Debt thresholds and indicators
- Comprehensiveness and seniority (equity among creditors, collective action issues)
- Impartiality (institutional)
- Institutional oversight and the relation between international and domestic levels.