As if Argentina did not have enough of a vulture fund-induced headache with the Frigate Libertad held up in Ghana, a November ruling by US judge Thomas Griesa in favour of these funds put the country on the brink of a debt default. The ruling was later overturned, but the heart of the matter -whether Argentina has to pay to the vulture funds and what would be the international consequences if it does- remains to be decided.
The Debt Swap
After a long cycle of indebtedness that started out during the last military dictatorship (1976-1983) and increased exponentially in the 1990s, Argentina defaulted on its sovereign debt in December 2001, in the middle of a massive economic and political crisis. It was considered the largest sovereign debt default in history.
In 2005, the then-president Néstor Kirchner annouced the beginning of a debt restructuring process, offering bondholders to swap their defaulted bonds for new ones of lower value, lower interest rates, and/or longer payment terms. This way, Argentina managed to renegotiate just over 75% of its debt.
In February of that year, and as a way to encourage investors to enter the debt swap, Congress passed a bill commonly referred to as ‘lock law’. This law prevents the government from starting up a new debt exchange process in the future, and also establishes that the defaulted bonds cannot be subject to any kind of judicial arrangement.
The ‘lock law’, however, was temporarily suspended in 2010 to allow for a new swap, and finally 92% of the defaulted debt was exchanged. The majority of the remaining bonds are in the hands of vulture funds, whose strategy is to buy defaulted bonds at rock-bottom prices and then litigate to have them paid at their nominal prices.
This is what NML Capital, Elliott Associates, and other such investment companies did. When the debt was originally issued, it was placed under the jurisdiction of the US judicial system, in a move to make the bonds safer and more attractive to investors. This is why the litigation is being carried out under the watch of judge Thomas Griesa of the second district court of New York.
Griesa’s latest ruling was a response to a request put forward by the Court of Appeals in November.
In February, Griesa had ruled on a case put forward by NML Capital (the same company involved in the Frigate Libertad affair), a hedge fund that owns defaulted Argentine debt, and which refused to take part in the 2005 and 2010 debt swaps. In that ruling, Griesa stated that Argentina must pay NML in full, and with interests, for the bonds it owns.
The ruling was based on a controversial interpretation of the legal concept of pari passu (Latin for ‘equal footing’). The judge interpreted it as meaning that when a country pays its restructured debt, it must also pay the total amount that is owed to the holdouts (those who did not enter the swap).
The sentence was appealed by Argentina, and on 26th October the Court of Appeals upheld the original verdict, but requested clarification on some matters regarding the implementation of the court order before issuing a final ruling.
In his response, considered unusually harsh by some analysts, Griesa stated that recent public declarations by President Cristina Fernández de Kirchner and Economy Minister Hernán Lorenzino regarding their refusal to pay the vulture funds constituted a violation of his February ruling. The ruling states that “Argentina is prohibited, during the appeal, from taking any action to evade” the payment.
Based on these declarations, on 21st November Griesa ruled that “(t)he less time Argentina is given to devise means for evasion, the more assurance there is against such evasion”, and ordered the country to pay US$1.33bn -the amount owned to NML and other vulture funds- into an escrow account to guarantee that if the Court of Appeals upheld his ruling, Argentina would not be able to evade the payment.
Griesa also tied up the payment to the vulture funds to Argentina’s payment to the exchange bondholders which was due on 15th December. This means that he instructed the intermediary bank (Bank of New York, or BNY) to not pay the exchange bondholders on 15th December unless Argentina deposited the US$1.33bn. This way, the choices for Argentina would have been to either pay everyone (including the vulture funds) or no one, thus defaulting on its debt to the exchange bondholders.
Advised by their US law firm, the Argentine government acted swiftly and sent a letter to the Court of Appeals on 26th November, the first working day after Griesa’s ruling. In it, they requested the court to grant a stay and maintain the status quo until the appeal process is complete, to “avoid irreparable harm to [Argentina] and numerous third parties.” The appeal process could go as far as the US Supreme Court, though there are doubts as to whether the Court would take the case.
On 28th November, the Court of Appeals ruled in favour of Argentina dismissing Griesa’s order and maintaining the stay until they reach a conclusion on the case. They set up a series of dates in which Argentina, the vulture funds, and interested third parties (such as the exchange bondholders) will have to file their papers, and scheduled a hearing on 27th February.
The letter submitted by Argentina also stated that a possible “remedy” to the situation would be if the court offered the vulture funds the same terms that Argentina offered holdouts in the 2010 exchange offer. “Under Argentine law, the Argentine Executive could present that proposal to Congress, but it cannot present a proposal that treats some creditors better than others, and it cannot fund an escrow.”
This has been seen as an indication that the government is willing to temporarily suspend the ‘lock law’ again, in order to re-open the exchange process and include the vulture funds. Its legal team hopes that the Court of Appeals will take note of the suggestion. So far, various opposition politicians have indicated their support for this alternative, and have said they would vote to amend the ‘lock law’ in Congress.
The case has caused international uproar, as the consequences of Griesa’s rulings could have, according to analysts, shaken the foundations of the financial system.
On one hand, Griesa’s November ruling put the BNY in a difficult position. As the bank acts on behalf of the exchange bondholders -not on behalf of Argentina- not paying them if Argentina decided not to pay the vulture funds would have put it in a breach of contract with its clients. The bank complained about this on a brief to the court, saying that they “should not be forced by Argentina’s independent violation of the Injunction to choose between exposing itself to the risk of contempt, on the one hand, or the risk of claims from Exchange Holders for breach of the Indenture, on the other.”
The Federal Reserve Bank of New York, the Clearing House Association, and the Depository House Company, all alarmed by the situation and its potential impact on financial markets, wrote to Griesa supporting the BNY’s position and requesting that “any order issued by the Court should be crafted not to apply to beneficiary’s banks, funds-transfer systems, or other parties in a funds transfer,” as this “could have operational ramifications that impede the smooth and efficient operation of the payments system.” They were concerned about the potential effects on investors’ confidence in the market -and in finance, confidence is everything.
But the main issue is still the judge’s interpretation of the pari passu clause and the order to pay the holdouts in full despite their refusal to accept a debt swap -twice- which casts doubts on the future of sovereign debt restructuring everywhere. Who will accept a massive reduction in the price of their bonds and longer payment terms, when they know they can obtain a favourable court ruling, such a Griesa’s, and get the full amount? How will countries face a default in debt payments under these circumstances?
A recent editorial on the Financial Times put it clearly: “Trapping countries in unpayable debt obligations is dangerous. While countries should service their debts in all but exceptional cases, an orderly mechanism for sovereign restructuring is essential for the exceptions.” This is particularly relevant at the moment, as many EU countries face the possibility of having to restructure their debts, Greece being the most urgent example.
Griesa’s ruling was a close call for Argentina, and speculation ran rampant as to what the country would have done if the Court of Appeals had sided with Griesa. However, the 28th November ruling only buys the country time to try and convince the Court to find a reasonable conclusion to the matter -such as reopening the 2010 exchange.
It is not clear whether the Court of Appeals will accept this suggestion, or uphold Griesa’s interpretation of the pari passu, but it is certain that there is much more at stake than Argentina’s claim. The world is watching.
Sovereign debt: Bonds issued by a national government in a foreign currency, in order to finance the issuing country's growth.
Default: The failure to promptly pay interest or principal when due. Default occurs when a debtor is unable to meet the legal obligation of debt repayment.
Debt restructuring: An operation used by countries to avoid defaulting on existing debt.
Debt swap (or debt exchange): Transaction by which external debt is swapped for other assets. In Argentina's case, this included exchanging defaulted bonds for new bonds of a lower value and longer payment terms.
Exchange bondholders: Holders of bonds who entered the debt swap.
Holdouts: Holders of bonds who did not enter the debt swap, in the hopes of obtaining better results through litigation.
Vulture fund: A fund that buys securities in distressed investments, such as high-yield bonds in or near default, or equities that are in or near bankruptcy. The goal is high returns at bargain prices.
Pari passu: A Latin phrase meaning “equal footing” that describes situations where two or more assets, securities, creditors or obligations are equally managed without any display of preference. Treating all parties the same means they are pari-passu.
Stay: The act of temporarily stopping a judicial proceeding through the order of a court.
Escrow: A financial instrument held by a third party on behalf of the other two parties in a transaction. The funds are held by the escrow service until it receives the appropriate written or oral instructions or until obligations have been fulfilled.
Collective action clause: A clause that allows a majority of bondholders to agree to a debt restructuring that is legally binding on all holders of the bond, including those who vote against the restructuring. This has been suggested as a possible solution to avoid cases like Argentina's.