Argentina's hedge funds case threatens sovereign debt restructuring

The ongoing legal battle between hedge funds and Argentina over the nation's 2001 debt default is an urgent reminder of the need for a sovereign debt workout regime.

Bhumika Muchhala

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SENIOR lawyers, fund managers and former policymakers are reported as saying that an initial New York court ruling against Argentina (as well as the sovereign debt crises in Europe) - in what has been dubbed by the Financial Times as the sovereign debt 'trial of the century' - highlights the weaknesses of the current ad hoc, contractual approach to government debt workouts.

Argentina was brought to court in New York by hedge funds led by Elliott Associates, creditors who have been claiming debt payments from the nation ever since its 2001 default. Argentina had reached an agreement with most of its private creditors to pay 25-35 cents for every dollar owed, in effect giving creditors about 30% of their money back in a restructured debt deal. However, some creditors such as Elliott Associates refused Argentina's restructuring deal, which in effect entailed a steep discount on the amount owed.

A subsidiary of Elliott Associates, NML Capital, is a US hedge fund that pioneered 'vulture fund' activity by winning a case against Peru in the 1990s, retrieving 400% what they paid for Peru's debt. Vulture funds purchase cheap debt from distressed companies or countries, and then seek repayment of the full face value together with interest, penalties and legal costs. If this repayment is not made by the borrower, the creditor can impound assets of the country or company in an effort to force repayment.

After years of pursuing Argentina through foreign courts, NML Capital impounded the Argentine naval vessel Libertad in the Ghanaian port of Tema on 2 October 2012. After months of seizure, the Libertad was recently released by an international tribunal and returned to Argentina on 9 January.

Argentine President Cristina Fernandez de Kirchner had condemned the Libertad's seizure and clarified that there would be no negotiations with creditors. She was quoted in a BBC article published on 25 October as saying that Argentina would not bow to 'blackmail by vulture funds'.

She asserted, 'As long as I am president, they can keep the frigate but nobody is going to keep the liberty, sovereignty and dignity of this country.'

Elliott Associates has convinced the US Appeals Court that Argentina cannot continue to pay holders of its restructured debt while ignoring creditors that refused to sign up to the restructuring deal. This argument is based on an obscure legal clause that promises equal treatment to Argentina's creditors.

The implication is that if and when Argentina pays off its debt to its creditors which accepted the restructuring, it must also pay off its debt to holdout creditors such as Elliott Associates, at 100% of the original loan. This would require Argentina to pay $1.33 billion to Elliott Associates if and when it made any payments on its new debt.

However, a stay was issued on the case by the US Court of Appeals for the Second Circuit on 28 November 2012, and an appeal against the court decision will be heard on 27 February. (The court heard the parties' arguments on 27 February but may take weeks or months to reach a decision.)  In the meantime, important aspects of the judgment still need to be confirmed by the US Court of Appeals, with the possibility that the case could end up in the Supreme Court.

If enforced, the ramifications for sovereign debt workouts would be enormous. A few creditors could prevent debt restructurings and negotiations, threatening the ability of sovereign states to achieve debt workouts and causing chaos in debt markets globally.

The creditors which accepted the restructuring receive payments from Argentina via banks based in New York, because when issuing the bonds Argentina placed itself under New York State jurisdiction. If the court ruling is enforced, the potential implications are such that the New York-based banks can only process payments from Argentina if the hedge funds are also being paid, something President Kirchner has vowed not to do. If Elliott Associates is triumphant in the February hearing, one possible consequence for bond issuers is that they may prefer to go through jurisdictions such as London or Frankfurt rather than New York.

Ultimately, if the hedge fund wins, the Argentine government could face a choice of making debt payments to the hedge funds at 100% of the original loan, or be forced to default on payments to all creditors.

Debt restructuring mechanism and the IMF

Some experts and observers argue that the time has come to revisit the sovereign debt restructuring mechanism proposed by the International Monetary Fund (IMF) in 2002, while others call for sovereign debt resolution mechanisms supported by an international debt court that is independent of the IMF.

The sovereign debt restructuring mechanism drawn up by former senior IMF official Anne Krueger was envisaged as a kind of voluntary Chapter 11 for countries. Due to US opposition, however, it never materialised. (Chapter 11 refers to the relevant part of US domestic legislation that provides for debt restructuring for businesses in bankruptcy situations.)

Creating a sovereign debt restructuring mechanism, either inside or outside the IMF, will pose a formidable challenge in generating the political will, in which the role of the US Treasury and Congress is pivotal. The US Treasury would have to seek congressional approval for the necessary change to the IMF's articles of agreement. Capitol Hill is likely to be highly suspicious of allowing an international institution to override, in effect, US bankruptcy proceedings. Legal experts doubt whether the US has enthusiasm for this.

Meanwhile, Jubilee Debt Campaign activists have publicly opposed the IMF as the institutional home of a debt resolution court or mechanism. In a letter to the Financial Times, Nick Dearden of Jubilee Debt Campaign UK argues that a debt court cannot be taken seriously 'if housed in one of the biggest creditors in the world', and that 'no court of law would be taken seriously if judge and jury were drawn from the prosecution'.

However, a comprehensive debt resolution mechanism is urgently needed. Such a mechanism has the potential to redress the power imbalance between debtors and creditors, which has devastated the economies of southern Europe and many developing economies. A fair and development-oriented debt mechanism could also enshrine the legal principle of 'odious debt' and strive to ensure that a government's international duty to respect its people's social and economic rights is no longer subordinated to external debt payments.

Jubilee Debt Campaign also placed an advertisement in an Argentine newspaper, the Buenos Aires Herald, on 11 January. The advertisement declares support for Argentina's right to refuse to pay the vulture funds, condemns the decision of the New York court which implies that payment to vulture funds supersedes a state's right to protect its people under international law, and calls for a debt audit in Argentina to ascertain the extent of illegitimate debt which should not warrant repayment.

Campaigners recall that Argentina was driven to debt default at the end of 2001 after three years of economic recession where the country was following policy conditions attached to bailout loans by the IMF. Over half the population, some 20 million people, were living below the poverty line and the public debt ratio was 160% of GDP.

After its debt default, Argentina's economy started growing out of several years of stagnation in a matter of a few months. Subsequently, Argentina became the fastest-growing economy in the Americas. Eleven million people were pulled out of poverty and unemployment more than halved in the following five years.

UN expert calls out against vulture funds

Meanwhile, the United Nations Independent Expert on foreign debt and human rights, Cephas Lumina, has stressed that successful debt restructuring for deeply indebted countries will be made impossible if vulture funds are allowed to paralyse debt relief.

In a UN press release distributed on 13 December, Lumina urged world governments not to allow vulture funds, such as NML Capital, to purchase debts of distressed companies or sovereign states on the secondary market for a sum far less than the face value of the debt obligation.

'From a human rights perspective,' the UN expert said, 'reduced debt burdens and increased fiscal capacity contribute to the creation of the conditions necessary for the realisation of all human rights, particularly economic, social and cultural rights.'

Lumina called on states to follow the example of the Channel Island of Jersey and the United Kingdom, which have recently adopted legislation to prevent vulture funds from pursuing excessive claims against heavily indebted countries before their national courts.

The UN press release also highlighted the UN Guiding Principles on Foreign Debt and Human Rights, which were endorsed by the UN Human Rights Council in June 2012.

The Guiding Principles underscore that states, international financial institutions and private companies have an obligation to respect human rights, including the duty to refrain from formulating, adopting, funding and implementing policies and programmes that directly or indirectly contravene the enjoyment of human rights.

According to the principles, 'loan agreements should impose clear restrictions on the sale or assignment of debts to third parties by creditors without the prior informed consent of the Borrower State concerned. Every effort must be directed towards achieving a negotiated settlement between the creditor and the debtor.'

They also state that 'creditors should not sell sovereign debt on the secondary  market  to  other  creditors that  have  previously  refused  to  participate in agreed debt restructuring'.                                            

Bhumika Muchhala is a researcher with the Third World Network in the area of finance and development.               

*Third World Resurgence No. 269/270, Jan/Feb 2013, pp 11-12