Changing the way sovereign debt works

Victory for a US vulture fund that could make solving the euro crisis even more difficult

By Tim Fernholz

When bankers and public officials huddle around tables in Brussels and Athens, trying to figure out how to keep Greece in the euro, their problems might be compounded by a lawsuit brought by an ornery US investment fund.

Whether seizing an historic Argentine naval vessel or trying to take the gold Argentina keeps in the New York Federal Reserve, the efforts of the New York hedge fund Elliott Associates and its subsidiaries  to recoup money the country owes them are relentless. Thanks to an Oct. 26 decision (pdf) in a federal circuit court, they are more likely than ever to get paid—and change the way sovereign debt works.

In 2001, Argentina defaulted on its debt. It eventually went through two restructurings, in 2005 and 2010, to begin paying consenting bond holders between 25 and 29 cents on the dollar value of its bonds (i.e., a “haircut” of up to 75%). Elliott, earning the moniker of “vulture fund,” had bought up the country’s debt on the cheap and did not participate in these restructurings, holding out and suing the country in US court for the $1.33 billion face value of its bonds.

While Elliott stews in legal limbo, Argentina pays restructured bondholders through a New York-based trust. The Oct. 26 decision essentially says that if Argentina is paying anyone, it has to pay Elliott, too, thanks to a (key vocab alert) pari passu clause in the bond’s contract. The Latin phrase means ” in equal step,” and says that Argentina will treat the bonds in question on equal terms with all of its external loans. Basically, the court says, pay everybody or pay nobody.

Since most of Argentina’s American assets are still off-limits from seizure, the most tangible part of the decision is the enforcement mechanism: It threatens to hold the Bank of New York Mellon, which disburses Argentina’s coupon payments, in a legal bind if the country tries to avoid paying all of its creditors. The scary thing for markets is another default, which could come to pass if Argentina fails to pay its current creditors in protest or avoidance of the ruling. The country’s sovereign rating was downgraded this week, and prices have surged on insurance against their default.

Can Argentina afford to pay the debt holders? With $46 billion in foreign reserves, it has the cash. But it says that the price, which ranges from $1.3 billion to $12 billion, would have severe economic consequences for a country that is expected to run a structural deficit of several hundred million dollars the first time in four years.

Reuters’ Felix Salmon, who has followed the story closely, sees Argentina’s bind (and the broader ruling) as a major shift in world of sovereign debt:

[T]his ruling is just one more step towards a world where the old verities about sovereign risk simply don’t hold any more. It used to be that sovereigns were sovereign: that was bad news if they unilaterally decided to default on you, but other than that it was pretty good news. Now, however, they’re at the mercy not only of unelected technocrats at places like the IMF or the ECB; they’re also at the mercy of unelected judges in New York. Sovereigns have less freedom of movement now than they have done in a very long time, and we’re only beginning to grok the implications of those constraints.

Particularly, Salmon worries—as does the United States’ government, which sided with Argentina in the case—that the precedent in this case could make it exceedingly difficult for countries to modify debt in the future. Argentina explicitly warned that Euro crisis-related restructuring both on-going and expected in Portugal, Italy, and Greece (the “PIGs”) will be made exceedingly complicated by the decision.

When countries end up in financial crises, they usually end up getting “bailouts” from the International Monetary Fund and other countries, but a key component of any rescue is usually some kind of “bail in,” which essentially means coercing or convincing bondholders into accepting the kinds of haircuts that Elliott is trying to avoid here.

For example, when Greece restructured its debt in March, it paid off the 3% of creditors (including Elliott) that held out of the process to avoid just this kind of legal wrangling. This new ruling adds weight to vulture funds’ ability to collect repayments, which suggests that in the next sovereign restructuring process, creditors will fight harder and be more likely to hold out.

The court takes solace in the fact that most sovereign debt being issued now comes with a collective-action clause that prevents hold-outs like Elliott and its subsidiaries from avoiding a broad push for a haircut, but American University Law Professor Anna Gelpern argues that those clauses are paper walls that won’t stop vulture funds from suing for face value. The court also notes that none of the PIG bonds are governed by New York Law, though that might not stop litigious creditors from seeking jurisdiction in the US.

Argentina is likely to appeal the decision to the Supreme Court, and the lower court still needs to explain its scheme for Argentina to pay its creditors pro-rata, which means final action on this matter will be delayed for months. But if you’re a European negotiator hoping to ease your country’s debt obligations, this is the last news you want to see.