Argentina’s 2001 economic crisis led to one of the most extensive sovereign debt restructurings in history. In hindsight, it was also one of the harshest, in terms of Argentina’s negotiating stance and the losses incurred by bondholders. Ninety-three percent of holders of Argentine sovereign bonds eventually accepted the terms of two restructurings in 2005 and 2010, but seven percent of bondholders, holding an approximate US $4 billion of Argentine sovereign bonds “held out,” or declined to accept restructured bonds. The plaintiffs in the litigation discussed in this post hold US $1.7 billion, which they seek to recover through litigation in US courts.
NML Capital and other hedge funds purchased the Argentine bonds on the ‘secondary market’, i.e. on the market of previously issued financial instruments, from the original owners of bonds. The business model of hedge funds specialising in distressed debt is to purchase sovereign debt or judgments against a sovereign on the secondary market at a deeply reduced price to their par and, by consistently holding out from the renegotiation process and aggressively litigating, recover the full value of the bonds. The Argentine bonds purchased by the hedge funds contained choice of forum clauses in favour of New York courts, choice of law clauses in favour of New York law and broad waivers of sovereign immunity. The combination of these clauses should havemade the effort of recovering the debt much less painful. However, the hedge funds’ continuous efforts to enforce US judgments in their favour around the world have so far been modestly successful at best.
In the view of many, the balance of powers may change as a result of the recent US litigation. The US court litigation discussed in this blog post has been called ‘the trial of the century’ or the litigation that will change the landscape of sovereign debt restructurings. It has been remarkable, as the hedge funds have come close to being repaid under the bonds purchased on the secondary market. In an unprecendented turn of the litigation, the holdout creditors have obtained third-party injunctions from US courts that have driven a sovereign state to default.
The US Litigation
The recent litigation in the US courts has focused on the nebulous pari passu clause in the Argentine bonds, which provides:
“The Securities will constitute … direct, unconditional, unsecured and unsubordinated obligations of the Republic and shall at all times rankpari passu without any preference among themselves. The payment obligations of the Republic under the Securities shall at all times rank at least equally with all its other present and future unsecured and unsubordinated External Indebtedness.”
The meaning and scope of the pari passu clause is controversial. Two main interpretations of the clause have been put forward. The first and more controversial construction argues that the clause requires equal payment to all bondholders. Under this construction, a sovereign debtor is obliged to pay to all bondholders, even those who held out from the sovereign debt restructuring. The second, conventional interpretation argues that the clause merely ensures equal legal ranking and no factual equality in terms of payment. Under this interpretation, the sovereign debtor may not legally subordinate the sovereign bondholders (e.g., through legislation that gives preference to another group of creditors), however the clause does not require payments to all bondholders. (See my blog post offering a third alternative reading of the clause.)
The Second Circuit Court of Appeal in NML v. Argentina has endorsed the former interpretation. The Court of Appeal found that:
“[W]e conclude that in pairing the two sentences of its Pari Passu Clause, the FAA manifested an intention to protect bondholders from more than just formal subordination. The second sentence (“[t]he payment obligations … shall at all times rank at least equally with all its other present and future unsecured and unsubordinated External Indebtedness.”) prohibits Argentina, as bond payor, from paying on other bonds without paying on the FAA Bonds.”
It has never been easy to enforce judgments against sovereigns. It was no great surprise, then, that the Argentine Republic did not comply with the judgment ordering it to pay its debts to the plaintiff bondholders. To date, the holdout creditors remain unpaid. But what is unique about this litigation is that the plaintiffs were able to secure injunctions from the US court preventing third parties located in the United States from executing Argentina’s payments to the restructured bondholders.
On the basis of the expansive interpretation of the pari passu clause, the third-party orders enjoined, under the risk of contempt of court, financial institutions—including the trustee under the bonds, Bank of New York Mellon—to make payments to the holders of the debt restructured in 2005 and 2010, until Argentina complied with the judgment and paid the plaintiffs in full.
As the deadline for payment under the restructured bonds approached, the rather reasonable expectation of the plaintiff bondholders was that Argentina would eventually prefer to pay the holdouts rather than default on the restructured bonds. This assumption proved incorrect. Failing all expectations, Argentina missed payments on its restructured bonds on 30 June 2014, which technically led it to default (though Argentina contests the default).
Argentina’s President, Cristina Fernández de Kirchner, introduced draft legislation that would offer restructured bondholders the option of shifting the situs of bond payments to Argentina and the applicable law to Argentinean domestic law. The aim of this legislation is to circumvent the enforcement of US judicial injunctions. The plaintiff bondholders argue that this would deal a fatal blow to their enforcement strategies. The legislation would also remove BNY Mellon as the trustee under the bonds and would replace it with a local financial institution not subject to the jurisdiction of US courts. Many have doubted the legality of the proposed swaps. Because the swaps are designed to evade the application of the US court judgments, any parties involved in making payments to the restructured bondholders that would ‘aid and abet’ them may be found in contempt of court. In addition, if done through a majority action clause (a contractual provision that allows the majority of bondholders to modify sovereign bonds, with binding effect upon minority bondholders) contained in a restructured bond, such a modification may be in breach of the implied good faith obligation owed by majority to minority bondholders.
More Litigation and Diplomatic Action
The failure of BNY Mellon to channel the payments to bondholders has sparked litigation by bondholders claiming that the BNY Mellon has failed to meet its obligations as trustee towards the bondholders by refusing to transfer money escrowed by the Argentine Republic to pay the bonds. A pending action before the Belgian Commercial Court seeks to force Euroclear and Bank of New York Mellon Brussels to honour their obligations to pass through funds received for the benefit of the Belgian plaintiffs under their euro-denominated exchange bonds. A similarly-drafted action has been brought before English courts.
The pari passu litigation has also prompted actions on the international level. First, Argentina repeatedly appealed to the White House to rein in the consequences of the pari passu decision, only to receive no positive response. Then, the Argentine Republic filed a complaint against the United States before the ICJ on the ground of “violations of Argentine sovereignty and immunities and other related violations as a result of judicial decisions adopted by US tribunals concerning the restructuring of the Argentine public debt.” The claim is predicted by many to fail for want of jurisdiction over the United States.
Following the pari passu litigation, many argued that there is an acute need to reform sovereign debt restructurings. IMF Chief Christine Lagarde suggested review of debt restructuring principles should Argentina default on its payment obligations as a result of the pari passu litigation.
Such reactions are somewhat exaggerated. A recent decision of the District Court for SDNY in Export–Import Bank of the Republic of China v Grenada, 2013 WL 4414875, 4 (S.D.N.Y. 2013) read narrowly the holding in NML v Argentina. In NML v Argentina, the court considered that Argentina passed legislative enactments and executive declarations that seriously affected the entitlements of creditors, in particular, the so-called “Lock Law” that prohibited the State from opening negotiations with holdout creditors. This stood in contrast from the less shocking case before the court where Grenada made payments to consenting bondholders and refused to pay to non-consenting bondholders ‘unless resources become available to do so’. Although some doubts remain, it still seems that the fears of collateral damage arising from the ruling in NML v Argentina are largely dissipated by this ruling. A general sense is that the judgment of the Second Circuit in NML v Argentina was largely predicated upon Argentina’s uniquely recalcitrant stance during its restructuring.
The force of the plaintiffs’ actions in the US court litigation lay in the combination of the pari passu clause and the equitable third-party orders. Absent third-party orders, the pari passu argument would not have gotten the plaintiffs so far. Sovereign immunity, the inability to compel a foreign sovereign and the weakness of contempt of court sanctions in respect of a foreign sovereign would have enabled Argentina to ignore the US court judgment. Only with the addition of third-party orders were the plaintiffs able to lead Argentina to default. Third-party injunctions are equitable in nature, and the judge enjoys broad discretion in their issuance. The overall context of any future sovereign bond litigation would be relevant to the decision whether to issue equitable third-party orders, and it may be reasonably assumed that such orders will be used sparingly – only in the most extreme of the situations.