Argentina Upsets the Restructuring Model, Again

 Roy C. Smith

The Supreme Court’s refusal on June 16^th to hear an appeal of lower court rulings upholding Argentina bond investors’ claims for payment has thrown a monkey wrench into sovereign debt restructuring, which for thirty years has been an important part of the international financial system.

The ruling, which entitles the hedge funds that bought defaulted Argentine debt to be paid full value, is actually a fairly narrow one. It applies only to Argentine debt issued under US law that was not exchanged in restructuring offers made by Argentina in 2005 and 2010. The lower courts held that under the “equal-treatment promise” inherent in US law, unexchanged “old” debt holders must be paid on their claims as long as “new” debt holders are being paid.

The hedge funds, which bought the bonds for pennies on the dollar at various times since 2001 have been very aggressive in pursuing their claims against Argentina. They have pursued activist strategies through litigation designed to force Argentina to buy back their bonds at a price approximating full value. Argentina’s president Christina Fernandez has repeatedly referred to them as “vultures,” and has insisted she will not pay “extortion” of as $15 billion in principal and accrued interest owed on the defaulted bonds. Since the Supreme Court’s decision, she will be forced to make payments on the held-back bonds if Argentina is to continue to pay on the rest of its debt.

Sovereign Immunity is Thrown Out

The ruling upset Argentina’s (and much of the rest of the world’s) expectation that the long-held notion of “sovereign immunity” would be upheld.

The highlights the difference between two classes of sovereign debt – those issued under local government laws with unquestioned sovereign immunity, and those issued under laws of established international financial jurisdictions such as the US and the UK, in which sovereign immunity had been presumed but not really tested.

Government debt issued under local laws is as sovereign as it can be – sovereign states are above the law. There is no bankruptcy law that applies to sovereigns, so creditors are stuck (as they have been since the Middle Ages) when they default and must accept whatever the sovereign offers in its effort to “restructure” the debt.

However, sovereign debt issued under US law, the Supreme Court has made clear, is hardly sovereign at all.  Creditors are entitled to the equal-treatment provision and may seek to discover and impound overseas assets of the defaulting government.

The Market Evolves

Prior to the 1980s, there was no market for bonds of Emerging Market countries because so many had defaulted in the 1930s and it took more than a decade to work out investors’ claims.

In the 1980s, many Emerging Market countries borrowed “petrodollars” from banks. This was money deposited in the banks by oil exporting countries after the four-fold price increase imposed in 1973. The price rise led to a world economic slowdown, and a shortage of foreign exchange that these countries needed to import oil. The banks, needing to lend out the petrodollars, offered Emerging Market governments dollar loans subject to US law. The countries, however, did not manage their finances well, and a decade later many of them defaulted.

During the 1980s, thanks to a plan designed by the US Treasury Department, banks could exchange their defaulted loans for new bonds issued by the countries that were collateralized by long-term zero-coupon US Treasury bonds. Because interest did not have to be paid until maturity, the bonds could be acquired at a very steep discount. The new collateralized bonds (called Brady Bonds after US Treasury secretary Nicholas Brady) were issued in exchange for the old loans, at a “haircut” (discount) of about 30% of the face value of the defaulted bonds. $70 of new bonds would be offered to replace $100 of old loans. The banks had already written the loans down to about that level.

As a relatively small group of international banks (not a bunch of hedge funds) were the loan holders, there were few holdouts that did not accept the terms of the exchange, though there were some. The countries were able to reduce the old debt on their books by 30%, to end their defaults and renew their access to markets. The new bonds traded actively and several went to premiums. Henceforth, market prices would reflect the economic conditions of the country, reflecting a probability of default.

After this, the market for Emerging Market sovereign debt expanded rapidly, and provided access to financing sources for dozens of countries they were quick to utilize.

After Brady Bonds

There were a number of defaults or near-defaults along the way that resulted in restructuring operations, in which the governments involved would offer new bonds to replace old ones. There was always a haircut in the process of between 30% and 40% depending on the market price of the old bonds at the time.

The exchange offers were always conditional on a minimum percentage of the old bonds being tendered for exchange. As most investors estimated the market value of the new bonds to be somewhat greater than the market value of the old, most were happy to participate in the exchange.

The net result was that exchange offers could reset a sovereign’s credit position, from bad to better, over a relatively short time period that would enable countries to regain access the markets quickly. The terms of the exchange would depend on negotiations between creditors and the governments, often with IMF oversight and endorsement. These would require some improvement in the economic and financial management practices of the countries. It wasn’t the same as a bankruptcy proceeding, but it had a similar effect. 

But some hedge funds thought they could do better by buying old bonds, often at discounts from their market prices, and not exchange them – in the hopes that they could negotiate quietly with the government to buy back the old bonds at a profit. This process might involve a few years of waiting, with no return on the bonds in the meantime, and some additional cost in litigation expense, but it they made enough nuisance they could expect to be bought out sooner or later. Many were.

Argentina Upsets the Norms

Argentina, however, upset things when in defaulted in 2001 on $90 billion of foreign debt, requiring the world’s largest restructuring. Argentina did not follow standard procedures of negotiating with creditors with IMF assistance. In 2004, it took a much more aggressive position, offering a 70% discount. It refused to accept a “traditional” discount of 30%; it wanted to maximize debt reduction in the exchange, which meant a much larger discount. The creditor committee, backed by the IMF, was furious but the market price of the outstanding old debt was about 30 percent of face value, justifying Argentina’s notion of a 70% haircut.

Seeing no better alternative, investors gave in; 75% of the bonds were tendered and the deal went through. There were a few hedge fund holdouts that figured that they could pressure the government into buying them out at a profit.

In 2010, Argentina offered the holdouts a slightly better deal, but the funds rejected this offer too. Instead, they increased their legal harassments, commencing the suit that was declined for review by the Supreme Court and suing to impound Argentine assets abroad.

Then Greece

Also in 2010, the sovereign bond market’s attention had turned to Greece, a member of the EU and therefore not generally considered an Emerging Market country. It was, nonetheless, in great financial difficulty following the global financial crisis that began in 2008, and in 2012 it needed to restructure its $200 billion outstanding foreign debt then trading at 30 cents on the dollar. The debt was not in default, but was getting close.

The Eurozone countries had already provided some assistance to Greece, but more was needed. Some thought they would ultimately bail out the debt, but others thought German reluctance to do so would prevent it.  In time there was a compromise – Greece would restructure its debt and do a number of other things to improve its financial position, and the Germans would go along. The exchange offer involved new bonds supplemented by a note of the European Financial Stability Fund and that package was determined to have a net present value of 70% of face value (but the cash vale was more like 55%.

But the Greeks realized that even with the EFSF note, the exchange might not meet the 75% minimum exchange that was required, so the parliament enacted a law that added a retroactive “collective action clause” (CAC) to outstanding debt issued under Greek law. As an EU and Eurozone member country, Greece had been able to issue most of its debt under Greek law. A collective action clause provides that if a supermajority of the bonds held are voted in favor of some action affecting all the bonds, the majority may bind the minority to accept the action. Naturally investors do not like CACs, so most Emerging Market sovereign bonds don’t have them.

Doing this retroactively, of course, is contrary to the law just about everywhere, but in Greece, sovereign immunity would prevent contesting it. As a result, the exchange offer went through. Tellingly, the Greek government later bought out at 100% of par value a small portion of Greek debt issued under UK law rather than face a lawsuit in the UK similar to the ones that the hedge funds were pursuing against Argentina in the US.

Argentina in a Bind

The Supreme Court’s action puts Argentina in a bind. In order to continue paying principal and interest due on its previously restructured bonds, it must make similar payments on the old bonds, which Argentina claims would amount to $15 billion. It floated a scheme to force a conversion of restructured bonds (issued under US law) to new bonds issued under Argentine law, but doing so would not escape the US lower court rulings. Defying these would expose Argentina to having government assets held in the US and elsewhere being impounded.

For the Future

The significance of the Supreme Court’s action is that future Emerging Market sovereign debt restructurings have been made more difficult and expensive, and investors are now more aware of the difference between US and local law and will be reluctant to give up the added protection of US law which substantially limits sovereign immunity

It also should result in sovereigns insisting on including CACs in their loan agreements to be sure they can eliminate holdouts in any future restructuring. For now, anyway, while interest rates are low they should be able to do so as the market for high yield Emerging Market sovereign debt is hot. When markets are hot, investors agree to almost anything.