21 July 2014
Ousmène Jacques Mandeng, Global Institutional Relations Group, Prudential Investment Management
The decision of 16 June by the U.S. Supreme Court to deny a petition filed by Argentina in relation to holdout claims serves as an important reminder of persistent major uncertainties in the principles guiding sovereign debt workouts. The petition was to review a decision of the U.S. Courts of Appeals affirming district court orders of 7 December 2011 for full payout to holdouts of Argentina’s 2005 and 2010 debt restructurings. The decision affirms ambiguity of at least five key aspects of sovereign debt restructuring: What equitable distribution or pari passu means, what rateable payments are, the relevance of collective action clauses (CACs), the seniority in distribution of the International Monetary Fund (IMF) and the role of payment agents in dispute cases. Noting that the relevant U.S. court maintains that there are very limited broader implications of its ruling amid the extraordinary circumstances of Argentina, the decision is deemed here to have major adverse repercussions on the incentives for participating in sovereign debt restructurings. This risks unduly inflating the costs of sovereign default.
The preservation of inter-creditor equity in distribution is considered to be a fundamental objective of corporate bankruptcy proceedings and is seen here as equally fundamental to guide any sovereign debt restructuring. Importantly, in corporate bankruptcy proceedings, all parties are bound by the court orders and normally bankruptcy statues almost always provide for a ladder of priorities of claims. However, in sovereign bankruptcies, no court recourse is typically possible and countries can normally not be liquidated. In a sovereign default therefore, the sovereign can decide who to pay and must negotiate with individual creditors or creditor groups to achieve a required remedy. Establishment and preservation of inter-creditor equity in distribution therefore constitutes a major challenge in sovereign debt restructurings.1
Controversy regarding sovereign debt restructuring is of course not new. In 2002, the IMF embarked on a comprehensive review to establish a framework for sovereign debt restructuring.2 The main motivation was largely the lack of predictable and orderly restructuring of sovereign debt. The IMF outlined a proposal based on the design of a Sovereign Debt Restructuring Mechanism (SDRM) offering a possible statutory approach to sovereign debt restructuring largely for external indebtedness and excluding claims by international financial institutions. The SDRM was never adopted in large part amid resistance by some countries to subordinate their debt obligations to external legislation. While the SDRM may have been too ambitious in its objective and reach, the Argentina case and also the Greece debt restructuring of 2012 though seem to revive the view that some form of SDRM is still needed.
The present note aims to briefly discuss possible implications of the U.S. court ruling on Argentina for future sovereign debt restructurings. It does not provide a legal opinion, it focuses only on the appeal from the amended injunction issued by the U.S. District Court for the Southern District of New York, it is not to question the court’s rulings, nor the merit of the holdouts’ case nor whether the Republic of Argentina can make payments as implied by the court ruling. Review and content of the court’s rulings merely serve as background.
The Republic of Argentina declared a moratorium on principal and interest payments in December 2001 on more than US$80 billion of its external debt (old bonds) as identified by the U.S. courts. In 2005, Argentina after protracted and acrimonious negotiations offered an exchange of old bonds subject to the moratorium for new bonds (exchange bonds). Argentina renewed the exchange offer in 2010 for untendered old bonds for another batch of exchange bonds. The 2005 and 2010 exchanges offered exchange bonds for US$0.25 and US$0.29 to the dollar of old bonds. The two exchanges attracted 91 percent of the holders of old bonds. Argentina has continued to make payments to holders of the exchange bonds and failed to make payments to the holders of old bonds. The Republic categorically refused and passed legislation prohibiting any payments to holdouts (Lock law).
The holdouts, holders of old debt that had not participated in the debt exchanges, claim full payment under the provisions of the old bonds issued pursuant a 1994 fiscal agency agreement and initiated litigations against the Republic of Argentina (the claim of full payment is not in dispute). The plaintiffs (appellees) include NML Capital and others and the defendant (appellant) is the Republic of Argentina. The plaintiffs, after years of unsuccessful efforts to enforce money judgements (a court order that awards the plaintiff a sum of money) against the Republic, added claims for equitable relief (injunction). The plaintiffs allege that the Republic violated the pari passu provision in the old bond contracts by subordinating the old bonds to the exchange bonds.
On 7 December 2011, the U.S. District Court for the Southern District of New York (district court) held that the Republic had violated the pari passu clause by continuing to pay holders of exchange bonds without paying the overdue amounts on the old bonds.3 On 26 October 2012, the U.S. Court of Appeals for the Second Circuit (appeals court) affirmed but remanded in part the district court’s ruling to provide clarification on the payment formula and the injunction’s applications to third parties and intermediary banks. On 23 August 2013, the appeals court accepted the district court’s ruling as amended (amended injunction). On 16 June 2014, the U.S. Supreme Court decided to deny a petition by Argentina to review the decision of the appeals court.
The Republic has de facto exhausted available legal remedies and now would be in contempt of court by making payments to holders of the exchange bonds and not also make overdue payments to holders of old bonds. The next payment due to holders of the exchange bonds was 30 June 2014 with a 30-day grace period. If at the end of the grace period, the Republic has not made the payment to holders of the exchange bonds it would be in default to holders of the exchange bonds. The district court may extend a stay of its decision.
Pari passu clauses are widespread and embedded in most bond contracts. The court focused on what constitutes subordination under the pari passu clause in the Argentine old bonds contracts (other pari passu clauses may be different from the one used for the old bonds): “The Securities will constitute [...] direct, unconditional, unsecured and unsubordinated obligations of the Republic [of Argentina] and shall at all times rank pari 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 [...].”4
The district court’s ruling is interpreted here to have several important implications for sovereign debt restructurings including but not limited to:
Equal treatment or pari passu: The appeals court emphasises that the meaning of pari passu remains far from being settled nor uniformly understood.5 This argument was used to dismiss the defendant’s claim that the pari passu clause is merely a boilerplate provision to protect bond holders from legal subordination.
The appeals court refers principally in its conclusion to the second sentence of the pari passu clause as the “equitable treatment provision” stating that it “prohibits Argentina [...] from paying on other bonds without paying on the [exchange bonds]” and “giving priority to other payment obligations.”6 The appeals court also highlights that the first sentence of the pari passu clause was violated by the passing of legislation in Argentina preventing any payments under the moratorium (Lock law) thereby causing legal subordination of old bonds to exchange bonds. The court also specifies that the timing of payment to holders of old bonds has to occur before or when the Republic pays holders of exchange bonds.
The appeals court further maintains that “it is equitable for one creditor to receive what it bargained for, and is therefore entitled to, even if other creditors, when receiving what they bargained for, do not receive the same thing.”7 This seems to undermine the notion of inter-creditor group equity (“equality of treatment”) that has guided inter alia sovereign debt restructuring of the Paris Club and has constituted a fundamental principle to ensure adequate burden sharing between private and official creditors.8
The appeals court stresses that the breach of the pari passu clause in the case of the Republic of Argentina rests on the combination of Argentina’s legislative acts and the court’s interpretation of the equal treatment provision. The court therefore believes that the Argentina case is exceptional and that the “decision does not control the interpretation of all pari passu clauses. [The court stressed that it had not ] held that a sovereign debtor breaches its pari passu clause every time it pays one creditor and not another, or even every time it enacts a law disparately affecting creditor’s rights.”9 However, the broad-based similarities between Argentina’s pari passu clause and pari passu clauses in other bond contracts is seen here to raise the risk considerably that the court’s ruling will be used to guide general interpretations of pari passu clauses.
The ruling is interpreted here to give considerable weight to the notion that equitable treatment means that all holders of sovereign bonds must be paid when and if payments are due under the terms they have negotiated and that those terms may not need to be equitable between them. In the case of sovereign debt restructuring in the absence of a court binding all parties to a debt restructuring, the latter seems to facilitate a sovereign’s discretion in observing inter-creditor equity.
Rateable payments: The district court’s injunction provides that “whenever the Republic pays any amount due under the terms of the [exchange] bonds,” it must [...] pay plaintiffs the same fraction of the amount due to them (the “Rateable Payment”).10 The amended injunction of the district court explains that “[i]f Argentina pays Exchange Bondholders 100% of what has come due on their bonds at a given time, it must also pay plaintiffs 100% of the roughly US$1.33 billion of principal and accrued interest that they are currently due.”11 The olds bonds have been accelerated by the plaintiffs and therefore all principal is outstanding plus accrued interest. This implies that the notion of equitable treatment in payment is to be interpreted as payments of similar percentages of a given amount due at a given point in time.
Role of payment intermediaries in dispute cases: The court’s ruling affirms that all intermediaries facilitating payments on the Republic’s exchange bonds would be in contempt of court. The amended injunction covers the Republic of Argentina, the indenture trustee(s), the registered owners and the clearing systems. The ruling “provides notice to payment system participants that they could become liable [...] if hey assist Argentina in violating the district’s court order.”12 The court has not determined what entities act as intermediaries in the sense of the amended injunction and left it to future proceedings whether an institution has or has not assisted Argentina in a payment transaction. This raises uncertainty about the liabilities arising for payment intermediaries in sovereign debt restructuring cases and may raise payment intermediaries’ vulnerability to holdout litigations.
The appeals court further mentioned outside its ruling:
Collective action clauses (CACs): The court’s statement offers an interesting reminder of the limitations of CACs. The court observes that because newer bonds almost universally contain CACs the likelihood of a repeat of an Argentina-type restructuring is low.13 CACs normally require 66 to 75 percent of holders of the aggregate principal amount of a given bond series to constitute a qualified majority needed to amend contractual terms. However, the court acknowledges that with CACs if there are enough holdouts for a single series it may defeat restructuring of that series while still allowing restructuring of other series.14 The court’s view regarding CACs highlights that while CACs may increase the threshold for holdouts they may not prevent holdouts.
International Monetary Fund (IMF) as preferred creditor: The court’s deliberation provides a glimpse into the interpretation of the status of the IMF relative to other claimants. The IMF has been universally seen as a senior or preferred creditor. This rests largely on the notion that the IMF acts as lender of last resort when providing financial assistance to countries. However, this contention has no legal basis (the IMF Articles of Agreement make no provision for the IMF’s creditor status) and has not been tested in the courts. The court maintains that “[Argentina’s] case presents no claim that payments to the IMF would violate the [old bonds].” However, the court by making reference to appellees’ concerns indicated that “a court addressing such a claim in the future will have to decide whether to entertain it or whether to agree with the appellees that subordination of ‘obligations to commercial unsecured creditors beneath the obligations to multilateral institutions like the IMF would not violate the Equal Treatment Provision for the simple reason that commercial creditors never were nor could be on equal footing with the multilateral organisations.’”15 The IMF’s preferred creditor status has remained an essential feature of the IMF’s operations and ability to act. The court’s opinion though has affirmed that there is considerable uncertainty as to the robustness of the basis for the IMF’s preferred creditor status.16
The ruling and the appeals court’s statements have highlighted that considerable uncertainties remain concerning basic principles guiding sovereign debt restructuring. The ruling is interpreted here to have provided relatively firm guidance on the meaning of equitable treatment and timing of payments in restructuring cases. Both here are seen to complicate sovereign debt restructurings as they raise incentives for holdouts in particular amid acceleration provisions and due to the possible obligation of concurrent payments to holdouts. The inter-creditor group equity issue the ruling raised also adds a complication in particular when involving official and private sector creditors.
The appeals court’s statements may also have undermined the relative comfort provided by CACs for orderly sovereign debt workouts. It may also have raised the sceptre of litigation vulnerability of the IMF and payment intermediaries. While the ruling of course refers to New York law and therefore has no direct international implications, it is assumed here that it is likely to influence other jurisdictions given the importance of New York law for international bond contracts. The ruling is therefore seen to raise generally the uncertainty of distribution outcomes and could increase considerably the threshold for voluntary participation in sovereign debt restructurings. At the same time, it should raise incentives for revisiting the case for a framework statutory or otherwise for sovereign debt restructuring proceedings.
1 See e.g. Ousmène Mandeng, Intercreditor distribution in sovereign debt restructuring, IMF Working Paper, September 2004.
2 See e.g. Anne Krueger, A new approach to sovereign debt restructuring, IMF, 2002.
3 United States District Court of Southern District of New York, NML Capital, LTD (plaintiff) against Republic of Argentina (defendant), 08 Civ. 6978 (TPG), 09 Civ. 1707 (TPG), 09 Civ. 1708 (TPG), Order, 7 December 2011.
4 United States Court of Appeals for the Second circuit, 12-105(L), NML Capital, Ltd v. Republic of Argentina, decided 26 October 2012. A similar wording is being used in the exchange bond offer: The Republic of Argentina, Offers to Owners of EACH SERIES OF BONDS LISTED IN ANNEX A TO THIS PROSPECTUS SUPPLEMENT (collectively, the ""Eligible Securities'') to exchange Eligible Securities for its PAR BONDS DUE DECEMBER 2038 (""PARS''), DISCOUNT BONDS DUE DECEMBER 2033 (""DISCOUNTS''), QUASI-PAR BONDS DUE DECEMBER 2045 (""QUASI-PARS'') AND GDP-LINKED SECURITIES THAT EXPIRE IN DECEMBER 2035 (""GDP-LINKED SECURITIES''), Prospectus Supplement to Prospectus dated 27 December 2004.
5 Idem United States Court of Appeals 2012.
6 Idem United States Court of Appeals 2012.
7 Idem United States Court of Appeals 2012.
8 Argentina concluded a debt restructuring with the Paris Club on 29 May 2014.
9 Idem United States Court of Appeals 2012.
10 Idem United States Court of Appeals 2012.
11 United States Court of Appeals for the Second Circuit, 12-105(L), NML Capital, Ltd. V. Republic of Argentina, Decided 23 August 2013.
12 Idem United States Court of Appeals 2013.
13 E.g, in the European Union, all euro area government securities issued after 31 December 2102 must contain collective action clauses following the European Council decision of 24-25 March 2011. Argentina’s exchange bonds also contain CACs.
14 Idem United States Court of Appeals 2013.
15 Idem United States Court of Appeals 2013.
16 IMF Executive Directors highlight the importance of the IMF’s preferred creditor status (IMF Public Information Notice 04/16, 5 March 2004): “Directors emphasized that the Fund's preferred creditor status-that is, members giving priority to repayment of their obligations to the Fund over other creditors-is fundamental to the Fund's role in the international financial system and to the Fund's financing mechanism. They noted that the preferred creditor status has allowed the Fund to take the necessary risk to provide financial assistance to members in exceptionally difficult balance of payments situations, in support of their efforts to implement strong adjustment policies without resorting to measures destructive of national and international prosperity. Directors observed that Fund members have a long history of supporting the Fund's preferred creditor status, which benefits the Fund's membership, official and private creditors alike.”