Don't Fix It, Call It a Risk Factor! (Updated)
NML v. Argentina is seeping into securities disclosure for sovereign debt. For example, Colombia and Paraguay have recently told investors in their bonds that ongoing litigation in the Second Circuit could make sovereign crisis management harder going forward. Following from the Risk Factors section of Colombia's latest prospectus:
Recent federal court decisions in New York create uncertainty regarding the meaning of ranking provisions and could potentially reduce or hinder the ability of sovereign issuers to restructure their debt.
In ongoing litigation in federal courts in New York captioned NML Capital, Ltd. v. Republic of Argentina, the U.S. Court of Appeals for the Second Circuit has ruled that the ranking clause in bonds issued by Argentina prevents Argentina from making payments in respect of the bonds unless it makes pro rata payments on defaulted debt that ranks pari passu with the performing bonds. The judgment has been appealed.
We cannot predict when or in what form a final appellate decision will be granted. Depending on the scope of the final decision, a final decision that requires ratable payments could potentially hinder or impede future sovereign debt restructurings and distressed debt management unless sovereign issuers obtain the requisite bondholder consents pursuant to a collective action clause, if applicable, in their debt, such as the collective action clause contained in the bonds. See “Description of the Securities— Debt Securities—Default and Acceleration of Maturity,” “—Collective Action Securities” and “—Meetings and Amendments—Approval (Collective Action Securities)” in the accompanying prospectus. Colombia cannot predict whether or in what manner the courts will resolve this dispute or how any such judgment will be applied or implemented.
This seems to support the contention of Argentina and its fellow travelers that a victory for NML would be bad for the sovereign debt markets. But the disclosure also begs four questions.
First, why is the pari passu clause different from all other clauses? With other clauses, when we discover them to be ticking litigation time bombs, we try to redraft them. With pari passu, we let you know that you are buying a ticking time bomb. The answer might be that (a) pari passu is not different (lawyers always let sleeping dogs lie, and clients never call them on it), that (b) pari passu is not a mistake, but a commitment device -- and in any event of marginal relevance to upstanding debtors who will never default, or that (c) there is no way of fixing the problem until we know the precise outcome of the litigation. Which begs the next question.
Second, a simple investor, who spent the past year in a cave instead of following NML v. Argentina, might come away thinking that the case could turn out any which way. Yet the Second Circuit has said pretty clearly that pari passu means pro rata payment, and that this interpretation supports an injuction against the sovereign, which implicates some set of third parties. True, the pro rata formula and the boundaries of the set are still up for tweaking, and there is a nano-sliver of a chance of en banc review in the Second Circuit, and/or a hearing in the Supreme Court, with ultimate reversal -- but most likely outcomes would not reduce the risk disclosed.
Third, are Collective Action Clauses (CACs) good, bad, or risky? On the one hand, it is refreshing to see a technically correct description of the relationship between CACs and pari passu. Note that the excerpted text above does not say that CACs make the Second Circuit litigation irrelevant, but rather that pari passu goes away if the debtor has obtained the requisite bondholder consents under CACs--if it has them (Colombia and Paraguay do; Paraguay even has aggregation). A full cramdown is not a foregone conclusion, and not just because there is still quite a bit of CAC-less debt floating around: Greece failed to obtain "the requisite bondholder consents" in more than half of its foreign-law CAC-ful bonds, and has been paying its holdouts ever since. Nevertheless, the NML-specific disclosure makes it sound like CACs are a good thing. Yet the following risk factor comes just ahead of NML:
The bonds will contain provisions that permit Colombia to amend the payment terms without the consent of all holders.
The bonds will contain provisions regarding acceleration and voting on future amendments, modifications and waivers, which are commonly referred to as “collective action clauses.” Under these provisions, certain key provisions of the bonds may be amended, including the maturity date, interest rate and other payment terms, with the consent of the holders of 75% of the aggregate principal amount of the outstanding bonds. See “Description of the Securities—Debt Securities—Default and Acceleration of Maturity,” “— Collective Action Securities” and “—Meetings and Amendments—Approval (Collective Action Securities)” in the accompanying prospectus.
This disclosure of CACs as a risk factor goes back to their large-scale introduction in New York a decade ago (Happy Anniversary!!!) and betrays lingering unease about their place in sovereign debt contracts. Some folks still worry that CACs increase the probability of default and should carry a price penalty. For any individual bondholder, CACs carry a risk of being outvoted. For bondholders as a group, CACs may make an inevitable restructuring less disruptive, and increase recovery in default. I suppose whenever the question is CACs, the answer must be "All of the Above."
Fourth, what is the difference among "reduce," "hinder" and "impede" as they relate to sovereign ability to restructure, and how does using all three words help reveal the risk of NML v. Argentina? This one must be a long story. Recline and enjoy the meal.
UPDATE: The folks at FTAlphaville are running insightful and comprehensive coverage of the disclosure issue here.
The most interesting development comes from Belize, whose debt restructuring documentation goes beyond mere disclosure of the litigation to challenge the Second Circuit reading of pari passu directly. Not only does Belize use a narrow formulation of the pari passu clause (it refers to ranking but not payment), it also makes crystal clear the government's understanding "that this equal ranking status shall not require Belize to pay all items of its bond indebtedness on a ratable basis". The idea is to fix pari passu going forward in a way that denies future litigants the ability to use the fix to prove the clause had been broken. The National Assembly resolution for the restructuring says that the government has no authority to promise ratable payment, and that the clause has meant ranking-not-payment all along. Presto! -- drafters' intent is clear as day, if any judge ever cares to ask.
But if you were NML, you might even cheer this innovation: its successful argument against Argentina hinges on the word "payment," conspicuously absent in Belize. Put differently, while A promises that its debt and its payment obligations thereunder would rank equally, B only promises equal ranking for the debt obligations. The upshot might be greater differentiation between pari passu clauses that are ranking-only, and the (apparently pervasive) ranking-plus-payment ones. Then there is Italy.