States asked to effectively control vulture fund activities

A report by a UN human rights advisory body trains the spotlight on the “predatory” activities of vulture funds which profiteer from the debts of poor developing countries and which may impede the latter’s ability to realize basic rights obligations.

by Kanaga Raja

GENEVA: The UN Human Rights Council’s Advisory Committee has highlighted the growing concerns over the strategies employed by vulture funds and has recommended that states undertake a number of measures, both individually and in a coordinated manner, to effectively control their activities.

This recommendation comes in the Advisory Committee’s preliminary research-based report, prepared by Jean Ziegler, Rapporteur of the drafting group on the activities of vulture funds and their impact on human rights.

The Advisory Committee, which serves as a think-tank to the Human Rights Council and is composed of 18 independent experts, held its fifteenth session here on 10-14 August.

According to the report, which was considered at the session, there is no international legal regime that governs cases of state “insolvency” or “bankruptcy”.

“When a state defaults on its sovereign debts, it has to start, on its own initiative, a process of restructuring its foreign debt, which entails complex and protracted negotiations with a range of very different types of creditors, including private commercial creditors.”

Participation in such processes is voluntary and therefore, under certain circumstances, certain creditors may decide, for a variety of reasons, not to take part and to hold out for a higher level of repayment.

It is at this point that vulture funds come into play. They systematically hold out and/or collect and purchase from other bondholders the debt with the sole aim of obtaining a high return by suing the state in court. To that end, they make the most of existing failures in the system.

The report said that in the context of sovereign debt, a vulture fund is a hedge fund that invests in sovereign debt considered to be weak or in danger of default. These funds are not lenders but private funds that purchase the distressed debt on the secondary market at a discount, with a view to making a profit by suing the debtor for more than the price they paid to acquire the debt.

Their investment strategies are popularly called “vulture” because of their predatory modus operandi whereby they, amongst others, target sovereign states with distressed economies and generally with weak capacity for legal defence.

Poor countries targeted

The report said successful instances of litigation against poor developing countries outnumber by far those against any other group of countries.

According to World Bank estimates, nearly one-third of countries that are eligible for debt relief and other poverty alleviation programmes are targeted by nearly 26 vulture funds.

The report observed that vulture funds also refuse to participate in any orderly and voluntary debt restructuring processes. Once a state starts to negotiate a restructuring with private bondholders, vulture funds exercise their right to hold out or rather collect and purchase the distressed bonds in the secondary market. They then take advantage of the weak position of a country close to default by putting it under additional pressure.

Such pressure may easily end up in an agreement whereby the debtor state accepts a disadvantageous settlement as the only means to avoid a long and costly process against a particularly aggressive litigator.

This was the case with Greece in 2012 when the government decided to pay €436 million to settle a case with several holdouts on its debt restructuring. Dart Management, an investment fund based in the Cayman Islands, was accorded privilege in the payment, receiving 90% of that amount.

According to the report, Greece seemingly yielded to pressure, deciding to pay off the holdout investors in order to avoid being sued by the vulture funds, in the midst of the particularly unstable and sensitive political situation the country was going through.

To ensure the court’s decision is favourable to their interest, the report said, vulture funds choose “creditor-friendly jurisdictions”, usually the US or the UK. However, increasingly they sue in the debtor countries themselves, where weaker legal systems are easily overwhelmed by the level of technical detail involved in adjudicating such cases.

Cases brought by vulture funds are particularly protracted in that the medium estimate for recovery is six years, with annualized returns averaging from 50% to 333%. Such proceedings are always burdensome and can complicate financial and reserve management.

Vulture funds have averaged recovery rates of about 3 to 20 times their investment, equivalent to returns of 300-2,000%. In 1996, for example, Elliot Associates LP bought defaulted bank debt owed by Peru for $11.4 million (with a face value of $20.7 million) and in 2000 successfully sued the country for $58 million.

The International Monetary Fund (IMF) estimates that in some cases the claims by vulture funds constitute as much as 12-13% of a country’s gross domestic product (GDP).

The report stressed that given the high success rate of past litigation (72% of winning cases), lawsuits by vulture funds will most likely proliferate. It cited a recent study that found that between 1976 and 2010, there were about 120 lawsuits by commercial creditors against 26 defaulting countries in the US and the UK alone. Also, according to the African Development Bank, the reported number of outstanding cases against debtor countries has doubled since 2004, with an average of eight new cases filed per year.

“As a consequence, the likelihood of creditor litigation in cases of debt crisis has increased from less than 10% in the 1980s to more than 40% in recent years.”

The report said the recent outcome of the vulture fund litigation against Argentina and the ensuing changes in legal doctrine regarding the pari passu clause have opened the door to increasingly “disruptive” lawsuits not only against least developed but also against middle-income and highly developed countries.

“There is no doubt that, as things stand, the existing financial system offers opportunities for ‘vulture funds’ to profiteer at the expense of poor developing countries as well of creditors that have made sacrifices to let the country recover. Such a ‘perverse’ outcome has led to an increasingly broad agreement on the need to reverse this situation.”

Vulture funds have a long history of predatory practices against many developing countries including heavily indebted poor countries (the so-called HIPCs), mostly in Africa and the Americas.

According to the report, Africa is by far the continent most harassed by vulture funds, with an average of eight suits filed every year. Without the capacity or the resources to face complex and protracted processes, African countries have been particularly harassed by vulture fund litigation, losing the bulk of the suits.

High-profile cases

Despite vulture funds having operated in Africa since the 1990s, such actions went largely unnoticed among the general public until very recently.

It has taken a high-profile case, namely the dispute confronting the government of Argentina with one of the most well-known vulture fund firms, to prompt the international community to tackle the situation.

The report went on to cite a number of prominent cases, including that of Donegal International v. Zambia and NML Capital Ltd v. Argentina.

In the case of Donegal International v. Zambia, in 1979, the Zambian government bought agricultural equipment from Romania. By 1984, the government had difficulty servicing the debt, which amounted to about $30 million, interest included.

In 1999, just as Zambia was about to reach the decision point under the HIPC Initiative for comprehensive debt relief, Romania sold the debt to Donegal International (based in the British Virgin Islands) for about $3 million, equal to 11% of the debt’s face value.

In 2003, in controversial circumstances involving allegations of corruption and bribing of public officials, Zambia signed a settlement agreement with Donegal International in which it agreed to waive sovereign immunity from litigation and pay around $15 million of the then $44 million face value. It also agreed to penal rates of interest in the event of default and to have any disputes determined under English law.

Zambia paid a total of $3.4 million in three instalments and thereafter stopped paying, arguing that the agreement was tainted with corruption and had been signed without the requisite authority.

The company waited until 2006 when, months before Zambia was due to receive debt cancellation under the HIPC Initiative, it initiated litigation in the UK courts seeking $55 million. In February 2007, the English High Court ruled in favour of Donegal, but accepted one of Zambia’s defences that the stipulated interest rate under the settlement agreement was an illegal penalty. The end result was a reduction of Donegal’s claim to $15.4 million.

However, the report noted, this was still nearly 17 times the amount the company paid, constituting a 370% return on its “investment” and equal to 65% of the country’s savings in debt relief that year.

Reportedly, the government of Zambia recognized the judgment and allocated the funds originally earmarked for health programmes to service the debt.

The impact of the vulture fund’s claim on Zambia is striking, bearing in mind that about 65% of the amount it received in debt relief was intended to assist in development projects, the report underlined. The total expenditure of the central government on social benefits, according to the IMF, was around $140 million; thus the vulture fund took away almost 15% of total government social welfare expenditure.

“Money that could have been channelled to education, health care, and poverty alleviation thus had to be used to pay the ‘victorious’ vulture fund.”

“This case study shows that ‘vulture funds’ do not hesitate to interfere with debt rescheduling programmes set up for the poorest developing countries. They take over the benefits of such programmes, seizing on the opportunity presented by resources newly freed up or about to be released by debt relief,” said the report.

In the case of NML Capital Ltd v. Argentina, the report said, a recent decision of a New York court in litigation between vulture funds and Argentina has highlighted both the need to find better legal solutions for sovereign debt restructurings and the potential negative consequences of vulture fund activities on the enjoyment of human rights.

It noted that it is well documented how the deteriorating economic, financial and social situation led Argentina to a catastrophic collapse in 2001. Soon after defaulting, the government recognized the need to restructure the debt (roughly $81 billion).

In two successive exchange offers in 2005 and 2010, Argentina made an agreement with more than 92% of its creditors, getting them to take an approximately 70% “haircut” on their bond holdings. This was a quite successful outcome.

A group of bondholders led by NML Capital rejected the restructuring and sued Argentina for the full amount in the New York State courts.

Vulture funds had bought up part of the defaulted bonds on the secondary market just before the collapse in 2001, but most were purchased, at bargain prices, after the default and some even after the exchanges. It is claimed that the vulture funds paid around $48.7 million for more than $220 million in defaulted bonds.

Vulture funds constitute a minor part of the bondholders, only 1.6%. NML Capital is a hedge fund company based in the Cayman Islands and owned by Paul Singer.

With this case, they managed to win three major battles: getting the US judge to change the legal doctrine on the pari passu clause; a Second Circuit confirmation on that ruling; and a refusal by the Supreme Court to take the case, meaning it stood by the lower court’s decisions.

The report said that the US court’s ruling with regard to the pari passu clause represents a major departure from the traditional approach applied in sovereign debt restructuring processes. According to the ruling, this clause, instead of providing for contractual protection against “favoured creditors” who would otherwise be paid first, should be interpreted such that its holdings must have equal preference with regard to all other creditors.

“The consequences of the ruling are quite shocking: Argentina is requested to fully pay the ‘vulture funds’ before any of the restructured bondholders get paid. It is not surprising that this decision had been widely challenged, including by the US Government itself.”

Moreover, implementing the ruling would be very damaging for Argentina in practice since it could face demands from other holdouts and holders of restructured bonds for repayment on equal terms, said the report.

In November 2012, a US District judge ordered Argentina to pay NML Capital and other holdouts in full (roughly $1.33 billion), an amount that represents an exorbitant profit of about 1,600%. According to the report, the court ruled that Argentina could not pay any creditor until it had paid the holdout creditors. The Supreme Court, in June 2014, upheld that ruling, ordering the relevant US financial institutions to turn over to the vulture funds information about  the assets that Argentina holds  worldwide, including accounts held by entities of the Argentine government and by individual officials.

On 30 June 2014, when Argentina attempted to pay its restructured bondholders, the US District judge ordered the deposited money to be frozen.

Setback

The US rulings represent a setback for debt restructuring, damaging as well the current negotiations for the establishment of an international mechanism for sovereign debt restructuring, said the report.

“The US rulings not only represent a resounding victory for the hedge funds that did not participate in Argentine debt swaps but are also a setback for orderly sovereign debt restructuring ‘with consequences well beyond the borders of the United States and Argentina’.”

The US court’s ruling has created a negative precedent but at the same time has triggered wide-ranging and solid support for the position Argentina has taken against the vulture funds. This can be considered a positive and unexpected outcome, the report added.

The report noted that in terms of national legislation, as of today, only two countries have enacted legislation to prevent vulture funds from pursuing excessive claims against indebted countries before their national courts, namely, Belgium and the UK. Unsuccessful attempts were made to adopt such legislation in France and the US.

Vulture fund litigation is mainly sought before US courts and concerns firms that are registered under US domestic law. This is not by chance, said the report. Over recent decades, US legislation and its courts have been particularly permissive and favourable to vulture funds’ actions and interests. For this reason, that this country enacts legislation to stop vulture funds seems to be an essential step towards effectively avoiding this disruptive litigation.

The report also noted that over recent decades a growing consensus has emerged on the need to curb vulture funds’ activities. Social organizations have been calling for years for concrete action to address the “perversity”, “immorality” and “outrageous outcomes” of these predatory investments.

Increasingly, states both from developing and developed countries have expressed the need for a robust legal regulatory framework to restructure sovereign debt as a way of addressing the root causes of vulture funds.

Human rights impact

The ability of vulture funds to jeopardize the objectives of the IMF and World Bank HIPC Initiative makes clear that the implications of vulture funds’ activities are not exclusively financial or economic and, more importantly, that the adverse impact of these activities cannot be effectively addressed in an isolated or partial manner.

It is a fact that vulture funds’ activities have the ability to hinder and even jeopardize a state’s capacity to fulfil its human rights commitments, particularly those linked with economic and social progress, the elimination of poverty, and development, said the report.

While debts held by these private investment firms may represent a small fraction of poor countries’ debt, awards in vulture fund litigation undeniably represent a substantial burden on the budgets of already poor countries.

Harmful conditions of loans or high and abusive interest rates may make the repayment of debt extremely difficult and may place the state in a situation of having to repay far more than the amount originally borrowed.

The negative impact of vulture funds’ actions on the state’s ability to fulfil its human rights obligations will increase as a financial and economic crisis becomes harsher. So they may also contribute to exacerbating the adverse impact of the debt burden and may lead to harsh austerity measures involving cuts on public spending that may ultimately impact on the economic growth and development of the country and thereby on the enjoyment of economic, social and cultural rights. As a result, money earmarked for poverty reduction and basic social services, such as health and education, is diverted to settling the substantial claims of vulture funds.

The report said the case of Malawi constitutes a good example of how debt repayments may impact negatively on the enjoyment of certain rights. In 2002, following a poor harvest, seven million from a population of 11 million were left facing a serious food shortage because the government was forced to sell the maize from its National Food Reserve Agency to raise funds to repay loans. This example shows that vulture funds’ action ultimately may diminish the capacity of the country to create the conditions necessary for the realization of the rights of the people, in this case, the right to food.

More generally, it has been empirically demonstrated that in many of the poorest countries debt repayment is often carried out at the expense of basic human rights, including the rights to food, health, education, adequate housing and work. “Debt servicing and harmful conditions linked to loans and debt relief often limit investments in and undermine the provision of accessible public services.”

The report underlined that governments should not be placed in a position where they are unable to ensure the realization of basic human rights because of excessive debt repayments.

“The State’s responsibility to ensure the enjoyment of basic human rights may take priority over their debt service obligations, particularly when such payments further limit the country’s ability to fulfil its human rights obligations.”

It has been recommended in this regard that debt sustainability analysis should include an evaluation of the level of debt a country can carry without undermining its capacity to fulfil its human rights obligations, including the right to development. Thus, such assessments on debt sustainability should take due account of the potential adverse human rights implications of debt service.

The question of whether a state might be under an obligation not to repay its debt to vulture funds if it can only do so at the expense of neglecting the basic social needs of its people is highly controversial, said the report.

“It requires making a choice between contractual obligations toward creditors and social rights obligations towards the people of the country. But in the absence of a multilateral independent mechanism capable of solving disputes over the repayment of sovereign debt, debtor states have little choice but to prioritize their contractual obligations.”

It is a logical consequence of the evolution of human rights law that a state cannot decide to service debt at the expense of meeting its human rights obligations, particularly economic and social rights, including the right to development.

“Particularly in the case of immoral, disproportionate, and speculative claims deriving from debts that have been settled under abusive terms, it is required to take a more human-rights centred approach,” the report said.

The report recommended a number of positive actions that states could undertake in order to mitigate the negative effects of vulture fund activities, including cooperating to create an international enabling environment conducive to the universal fulfilment of economic, social and cultural rights; ensuring adequate regulation of vulture funds; encouraging through national regulations compliance by and requiring due diligence from vulture funds; and having an independent body undertake debt sustainability assessments. (SUNS8082)                         

Third World Economics, Issue No. 598/599, 1-31 August 2015, pp19-22