BackSave sovereign debt from vulture attacks
To secure sovereign debt from such attacks in future, drafting of instruments must replace vague phrases such as pari passu with precise ones
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The “sovereign debt trial of the century" has produced a judgement that is potentially disastrous for Argentina and threatens the future of sovereign debt itself. By refusing Argentina’s plea against the order by a New York Court, the US Supreme Court has left the country exposed to default on loans of over billions of dollars, which could reduce it to an untouchable in the world of international finance. The US government has stated that the effects of this case could “extend well beyond Argentina."
The case against Argentina was brought by Elliott Associates, a notorious vulture fund. Elliott first shot to fame when it brought, and won, a similar case against Peru in a Belgian court in 2001. That case was settled by Peru through a sum of $58million. Despite the tiny amount, it prompted the International Monetary Fund (IMF) to propose a separate court for sovereign bankruptcy. However, Argentina owes Elliott a humongous $1.5billion, and tremors of this case would be felt for long.
Argentina defaulted on its debt in 2001, filed under New York law, after which Elliott bought the defaulted bonds at deep discounts. Post-default, Argentina, using its privilege of sovereignty, offered its creditors a deal: Give us your defaulted bonds and we’ll give you new bonds instead, with lower face value. The offer was accepted by 93% of the creditors. However, Elliott held on to the defaulted bonds and thus turned into a “holdout" creditor. Post-restructuring, Argentina extended payments strictly to creditors who had accepted the offer. However, the New York court ordered Argentina to pay back Elliott all its due. More worryingly, it forbade creditors who had accepted the restructuring from receiving any payments unless holdouts were paid their due.
The ruling is based on a dangerously flawed interpretation of the pari passu clause. Pari passu literally means “equally" and is widely acknowledged as a boilerplate clause, which means it occurs frequently in sovereign and corporate debt instruments. The only intended purpose of pari passu is to prevent the debtor from legally subordinating one creditor to another, while making payments. So far, as is true for boilerplates, pari passu had been interpreted on the basis of a common consensus, so as to best serve financial markets. This consensus dictates that pari passu does not, in any way, forbid the debtor from making de facto preferential payments to its creditors. British courts have previously rejected similar cases based on this understanding of pari passu. In case of sovereign debt, the consensus around pari passu was first broken by its imaginative interpretation by the Belgian court against Peru. The court followed the so-called “ratable payment" doctrine in interpreting pari passu, which meant that as a remedy to violating pari passu, Peru was obliged to pay all creditors, including holdouts, on a pro-rata basis. If it failed to pay one, it would be forbidden from paying any. The NY Court has applied the same flawed logic to this case.
To be sure, Argentina is indeed in breach of pari passu, since it legally subordinated holdouts by passing a so-called “Lock Law," which prohibited payments to them. However, despite the breach, the remedy of ratable payments is unjustified. Debt restructuring occurs commonly in case of sovereign debt. Often, sovereigns run into trouble, and since they can’t declare bankruptcy, they force their creditors to accept unattractive restructuring offers. For that to happen, the sovereign has to prioritize creditors who accept restructuring over the holdouts; otherwise, no creditor will ever accept restructuring. This is why France and US came out strongly in favour of Argentina, because this is something any sovereign would, and must be allowed to, do. US argued that “selective repayment does not violate the clause," a point the court clearly missed. The ruling has put Argentina in the position of a tenant who is disallowed from paying her landlord to maintain her home, because she can’t afford to pay the milkman simultaneously. Moreover, the court has punished innocents by forbidding other creditors from accepting any payment.
The judgement will surely attract several other similar lawsuits, since pari passu clause exists in many sovereign debt clauses. This could mean the end of sovereign debt mechanism as we know it. Restructuring would be impossible since sitting on defaulted bonds and making billions through frivolous litigation a decade later is much more beneficial. The judgement also raises question marks on IMF’s current status as a de facto preferred creditor for all nations. Such judgements could nullify benefits of debt relief to Least Developed Countries. Status of New York as an international finance centre could take a major hit.
To secure sovereign debt from such attacks in future, drafting of instruments must replace vague phrases such as pari passu with precise ones. Collective action clauses, which enforce restructuring on all creditors, must be used to eliminate holdouts. A supra-national sovereign debt body, like the one proposed by IMF in 2005, could also be conceived. Hopefully, the judiciary will mend its ways to prevent such fiascos in future, though that looks increasingly unlikely. For now, the reputation and dignity of a sovereign has been hurt. Argentina, and all other indebted nations, must be saved from the vultures.
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