TWN Info Service on WTO and Trade Issues (Mar13/04)
18 March 2013
Third World Network
 
Argentina and hedge fund embattled in ‘debt trial of the century'
Published in SUNS #7542 dated 11 March 2013
 
New York, 8 Mar (Bhumika Muchhala) -- In what has been called the ‘debt trial of the century,' the protracted court battle between hedge fund NML Capital Ltd. and Argentina went before a three-judge appeals panel in New York on the afternoon of 27 February.
 
There were strong arguments from three attorneys: Jonathan Blackman, representing Argentina, Theodore Olson, representing NML Capital (the hedge fund that is pursuing this litigation), and David Boies, representing the Exchange Bondholder Group (holders of Argentina's restructured debt), as well as Bank of New York Mellon (the financial trustee for the restructured bonds).
 
The current debt trial against Argentina has shaken bond markets, worried bankers, lawyers and diplomats, captivated financial analysts and economic pundits and generated a vigorous debate over various issues, including the role of holdout creditors in sovereign debt restructuring, the pari passu clause in debt contracts which ensures equal treatment to all creditors, and the bankruptcy concept of fairness.
 
According to legal analysts, the court may not rule for several months. However, the appeal proceedings have significant repercussions on the ability of countries to restructure their debt successfully. In November 2012, a lower court order in New York obliged Argentina to pay the defaulted bonds of the holdout creditors, NML Capital and Aurelius Capital Management, amounting to a sum of $1.3 billion, whenever it makes payments on its restructured debt.
 
The argument of the holdout creditors uses the pari passu clause that enforces equal treatment to all creditors, including restructured and holdout creditors. This parity clause is embedded in sovereign debt agreements and is one of the key legal issues highlighted in this ongoing case.
 
The federal appeals court of New York consequently froze Argentina's payout and heard new arguments in the 2nd US Circuit Court of Appeals.
 
In the hearing that lasted through the afternoon, Argentina's attorney said that the lower court's ruling violates Argentina's sovereignty, threatens to trigger a new financial crisis in the country and quadruples the number of Argentine bond cases in New York federal courts, rather than resolving them. "We would not voluntarily obey such an order," Blackman said. "We're representing a government and governments will not be told to do things that fundamentally violate their principles."
 
The ruling by US District Judge Thomas Griesa has been described by news reports as an unusual proposal to force Argentina to pay. The judge wanted US financial institutions, such as Bank of New York Mellon which processes Argentina's payments to its bondholders, to become enforcers by diverting the payments that Argentina makes to its restructured bondholders if it doesn't first pay an equal amount to the holdout bondholders.
 
The purpose of the judge's ruling last year was to make it impossible for Argentina to settle any of its debts without also paying the hedge funds, thus putting it under more pressure to abide by the court's judgments. However, cries of protest rang out from banks, bondholders and the US Treasury Department, who collectively argued that the judge's solution unfairly punished bondholders who are not a party to the dispute between NML Capital and Argentina.
 
More than 92% of the debt from Argentina's world record $100 billion default in
2001 was restructured in 2005 and 2010. Argentina gave these "exchange bondholders" new bonds initially worth less than 30 cents on the dollar. Over the last decade, these exchange bondholders are slowly regaining their original investments, having been paid 71 cents for each dollar invested.
 
Argentina said that a ruling in favour of the holdout creditors would create an additional $43 billion in claims, which exceeds the nation's $41 billion in foreign exchange reserves. A spate of capital flight in the wake of this court case has further exacerbated the nation's potential solvency crisis.
 
Meanwhile, financial market analysts have argued that Argentina has numerous other sources of liquidity, including physical assets and state-owned enterprises, and is a G20 economy.
 
THE COURT DEBATE
 
The central debate between restructured bondholders and holdout bondholders is at the heart of this case. NML Capital says getting paid immediately in full, plus interest, is more than fair, because the plaintiffs spent millions litigating while the holders of swap bonds were getting regular payments. The exchange bondholders counter that there's nothing fair about taking other people's property, or getting as much as a 1,500% return on debt bought for pennies on the dollar.
 
The attorney for the Exchange Bondholder Group, David Boies, argued for differential treatment between restructured, legitimate creditors versus holdout creditors, saying that it is "inequitable" that the holdout creditors get multiple amounts of the face value of their debt. Boies also said that the jurors should prevent a second loss for exchange bondholders when they've already taken a haircut. "The right to payment for legitimate creditors should not be taken away when losses have already been internalized."
 
In response, one of the three appeals judges, Judge Reena Raggi, sharply clarified that "We're just here to enforce the existing contracts, not rewrite them."
 
Meanwhile, the attorney for NLM Capital, Theodore Olson, claimed that, "Argentina has not offered any proof that it cannot afford to pay the full amount we're asking for. Lack of ability to pay has not been addressed", adding that, "This is not 2001. Argentina has sufficient resources now, based on the amount of their foreign exchange reserves."
 
Other remarks by Olson cast the hedge fund as a "victim of a default" and the country's character as suspect. "Argentina has a lot of history in defaulting on its obligations. In fact, it goes back a couple hundred years," Olson said.
 
(The two attorneys, Boies and Olson, have some shared history, having argued against each other in the litigation that decided the US presidential election in
2000. Olson had represented Republican George W. Bush and Boies represented Democrat Al Gore.)
 
Meanwhile, Argentine President Christina Fernandez has vowed to pay the holdout creditors nothing unless they accept the same deal as the other bondholders. In response, NML Capital has aggressively pursued Argentina's assets around the globe, as witnessed by the seizure of an Argentine naval ship, The Libertad, in a port in Ghana. Argentina and the hedge fund have been warring each other in court since 2004; however, last week's case was being watched closely by the international media, bankers, lawyers and other financial actors because of its potential impact on unrelated debt disputes.
 
A BANKRUPTCY CONCEPT OF FAIRNESS
 
Argentina's contention that "equal treatment" could be provided through a new debt swap giving holdouts the same terms others accepted, is based on a bankruptcy concept of fairness. This concept says that when debtors can't pay, all creditors must suffer, accepting less so that recovery can happen more quickly.
 
Indeed, sovereign debt relief depends on such a bankruptcy concept of fairness, and many of the legal briefs produced on the case reflect a desire that the courts invoke it while engineering a comprehensive solution to Argentina's debt problems. Unfortunately though, as seen by the point-blank responses of the appeals panel, the judges are more likely to base their ruling in simple contract terms, as in, "they owe the money, and they need to pay."
 
The worst case scenario is one where Argentina would either have to begin paying the holdouts or default on all of its restructured debts. This could trigger a new economic crisis in the country. With this awareness, both the Obama Administration and Argentina have argued that the judge's remedy could make debt relief harder for troubled economies, dooming their citizens to more years of poverty than necessary.
 
A White House brief highlighted that this ruling could damage US foreign policy, threaten US assets overseas and even harm the dollar by persuading nations to take their bond business elsewhere.
 
THE SPECTRE OF VULTURE FUNDS
 
Argentina's government officials have publicly named the holders of the defaulted debt as ‘vulture funds'. Although the country's legislature passed a law barring payment of such funds in 2005, the government has spent the past decade opposing claims brought forth in US courts by holders of the defaulted bonds.
 
In these legal cases, many holders of the defaulted Argentina bonds have won US court rulings requiring the country to pay them. But despite the favourable rulings, courts have generally prevented the holders of defaulted debt from moving to seize the country's assets, citing the Foreign Sovereign Immunities Act, which limits the ability of plaintiffs to sue foreign countries in American courts.
 
Vulture funds are a type of highly profitable financial investment, in which a fund buys sovereign debt cheaply and then sues to enforce it. Benefiting from tax and jurisdiction loopholes, vulture funds create obscure societies or task forces to lobby for their interests in tribunals, legislative bodies and the media. Many of the nations that face vulture fund lawsuits are Heavily Indebted Poor Countries, including several countries in sub-Saharan Africa.
 
Vulture funds purchase debt claims as a secondary lender. This means that vulture funds are not primary lenders, but rather entities that have purchased the debt from some other source, such as a bank. Generally, these funds purchase debt involving highly distressed countries. Sellers are usually more than willing to rid themselves of these debts, because many of these debts may soon come into default or face restructuring negotiations.
 
The vulture funds purchase this debt as it is about to be written off. Then, they sue the debtor or borrower for the full value of the debt, plus interest and penalties. The lawsuits occur in national courts, often in the United States, Paris, or Brussels. Through litigation and negotiation, vulture funds have been able to secure a payout greater than the cost of the vulture fund's purchase.
 
One of the primary reasons why vulture funds are successful is because courts have been willing to enforce a vulture fund's right to collect the full value of the debt. Nations such as Zambia, Peru, and Argentina have all lost lawsuits to vulture funds.
 
The most important (and successful) argument justifying full enforcement is the standard pari passu clause in many sovereign debt agreements. These clauses require that all creditors be treated equally. Accordingly, a prominent Brussels court has held that pari passu clauses forbid states from paying only the restructured portion of their national debt without paying the vulture funds as well.
 
Therefore, if there is not enough money to go around, all creditors receive a pro-rata share and debtors are not allowed to pay off one creditor in full while leaving others unpaid. Because these clauses contractually prohibit a state from paying off one creditor before other holdouts, these clauses act as the key enforcement tool in the hands of holdout creditors.
 
States are thus forced to choose between appealing against court decisions that stop the restructuring because of the pari passu clause, or pay up in a settlement agreement with the vulture fund so that national debt restructuring can take place.
 
The tactics of vulture funds are deeply disruptive to debt restructuring processes that facilitate economic recovery in countries. The threat of a holdout may discourage other creditors from agreeing to a restructuring because creditors now can collect the full amount of the debt by suing, and because restructuring may be stopped by the courts under the pari passu argument.
 
Vulture funds put sovereign states in a difficult double bind. If a state chooses not to pay the vulture fund, that fund could call a default. On the other hand, when the state is prevented from paying the other creditors by a vulture fund, those other creditors may call for a default.
 
The likelihood of debt default may prompt a rush to grab the country's limited foreign exchange reserves, as creditors will attempt to get at whatever they can before a state goes into default. Most importantly, the ability to call a default by a vulture fund can trigger cross-default clauses in other debts.
 
ELLIOT ASSOCIATES
 
The hedge fund holdout creditor in the Argentine case, NML Capital Ltd., is a subsidiary of Elliot Associates based in the tax haven of the Cayman Islands.
 
The head of Elliot Associates is conservative financier Paul Singer, who is widely credited for enacting some of the most aggressive litigation cases against countries. In 1996, Singer won a lawsuit against the Peruvian government for a
400% profit. Subsequently, he sued the Republic of Congo for $400 million for a debt he acquired for $10 million. He ended up with $127 million from the litigation. One of the ways in which Singer's fund secures political support is through the American Task Force Argentina (ATFA), a lobby group that targets the US Congress to take sides with its litigation cases.
 
ARGENTINA'S POST-DEFAULT EXPERIENCE
 
The exorbitant payments to vulture funds are valuable foreign exchange resources that should be financing domestic development and growth needs of developing countries. As the Argentine Minister of Foreign Relations, Hector Timerman, said in a Huffington Post article published on 14 November 2012, "This is money that should be going to build roads, schools and other poverty reduction programs. Even worse, these nations are often on the receiving end of debt alleviation and international funding - which then goes to line the pockets of said vulture funds."
 
Ultimately, the overwhelming danger of vulture fund litigation cases is the risk of countries falling into financial crisis and economic recession. Conversely, equitable debt restructuring plays a significant role in enabling countries to recover from economic recession and prioritise their first duty to the welfare and rights of their own citizens over that of international financial actors and markets.
 
After Argentina defaulted over a decade ago, it reversed the austerity measures promoted by the International Monetary Fund, re-nationalised key productive sectors like aviation, pensions and most recently oil, increased social protection and income transfers to the poor, and reduced poverty substantially.
 
The ratio of debt service payments to exports fell to less than 20%. Unemployment decreased from around 22% to close to 7%. Real wages increased, and wage inequalities narrowed. As the nation became one of the fastest growing economies in the world, it demonstrated that its debt default and restructuring enabled a pathway out of economic recession and increasing poverty, and into domestic economic and social development.
 
NGO SUPPORT FOR ARGENTINA
 
On 27 February, the day of the appeals hearing, the US arm of the global Jubilee debt campaign and Third World Network held a vigil outside the New York Court building. The two organisations issued a joint press release to the media, titled "Arguments End in ‘Debt Trial of the Century': 2nd Circuit Court of Appeals to Rule on Vulture Funds and Argentine Bonds," that included statements by both organisations.
 
The statement by the Jubilee debt campaign said, "If the judges rule in favour of these hedge funds, it will mean these funds will more aggressively target poor countries in fragile financial recovery. If they rule with Argentina, it will mean that it will be harder for these types of funds to exploit countries in financial distress. The actions of NML Capital and Aurelius Capital hurt legitimate investors and poor people."
 
Third World Network said, "This case has huge implications for the international debt system precisely because it determines the ability of sovereign states to restructure their debt without being taken to court and held ransom by holdout creditors. Debt restructuring plays a significant role in enabling countries to recover from economic recession and prioritise their first duty to the welfare and rights of their own citizens over that of international financial actors and markets.
 
"Currently, there is no international debt restructuring mechanism, the absence of which allows hedge funds such as NML Capital to take Argentina to court. Vulture funds such as NML Capital speculate on the misfortune of countries and saddle developing countries with huge debt loads, depriving them of valuable financial resources badly needed for domestic development and growth."
 
THE NEED FOR A DEBT RESTRUCTURING MECHANISM
 
Various proposals on debt restructuring, including the IMF's sovereign debt workout mechanism (SDRM) proposed by Anne Krueger in 2001, have circulated in international organisations and within sovereign states.
 
One particular proposal is to establish a statutory sovereign debt restructuring mechanism by drawing on three key principles of Chapter 11 of the US bankruptcy law. First, is the enactment of temporary standstills on external debt, whether debt servicing difficulties are due to solvency or liquidity problems. The decision for a standstill should be taken unilaterally by the debtor country and sanctioned by an independent panel rather than by the IMF because the countries affected are among the shareholders of the Fund, which is itself a creditor.
 
This sanction would provide an automatic stay on creditor litigation. Such a procedure would be similar to safeguard provisions in the World Trade Organisation that allow countries to take emergency actions to suspend their obligations when faced with balance-of-payments difficulties. Debt standstills would need to be accompanied by regulations to stem capital flight.
 
A second principle is debt restructuring, including rollovers and write-offs, based on negotiations between the debtor and creditors, and facilitated by the introduction of automatic rollovers and Collective Action Clauses in debt contracts. This would essentially comprise a combination of voluntary and statutory mechanisms. However, if the debtor and creditors fail to reach agreement, there should be a process of fair and independent arbitration.
 
A third principle is that of automatically granting seniority status to debt contracted after the imposition of the standstill (the so-called debtor-in-possession financing in US law). Any lending into arrears provided by international financial institutions should be oriented towards trade financing, not the financing of debt payments or capital outflows. It should also be accompanied by the above principle of temporary standstills. +