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Revival on the Head of a Pin: Do U Pari Passu?

posted by Anna Gelpern

Argentina and its most intransigent creditors are duking it out again (or still) in the Second Circuit, reviving the crazy battle over the meaning and import of the pari passu (equal treatment) clause in sovereign debt contracts. For the small but committed contingent of pari passu pointy heads, this is WorldCupOlympicMarchMadnessSuperBowl. For everyone else, this bears watching because an obscure turn in the Argentina story could open the door to enforcement against sovereign debtors in general. (Nope, this is not a closet Eupdate. Pay no attention to the man behind the blue-striped curtain.)

Recap: Argentina defaulted on roughly $100 billion in debt in 2001, then restructured about three-quarters of it in 2005 with a 60%++ haircut, depending on how you count. In 2010, it mopped up most of the rest. However, a small subset of expert holdouts keeps on suing, lobbying, and trying to collect by any means necessary. Last December, the long-suffering SDNY Judge Griesa ruled that the Republic breached the pari passu covenant in its debt contracts by (a) paying the holders of its restructured bonds but not the holdouts, and (b) passing a "Lock Law" that bars the government from paying the holdouts. On February 23, the judge issued an injunction, telling Argentina to pay the holdouts pro rata whenever it pays the holders of its restructured bonds. Argentina has appealed, pointing out among other things that paying people who took a massive haircut on par with those who took none was not exactly equal or equitable. This week, the U.S. Government filed a Statement of Interest, joining the New York Fed and the New York Clearing House at a friend-filled party.

For those who care about neither Argentina nor pari passu, this matters because a broad reading of the February 23 SDNY order would subject countries who pay some creditors, but not others, to injunctions of the sort just slapped on Argentina. Creditors who get paid while the holdouts are not, or even intermediaries routing payments for the debtor, might be exposed as well. Pari passu clauses are ubiquitous in New York and English law sovereign bonds. Since successful sovereign debt exchanges so far have all relied on a credible threat of stiffing non-participants, upholding the order could spell the end of the prevailing restructuring regime.

A narrow reading of the order would tie the injunctive remedy much more closely to Argentina's "Lock Law." The law can be read as a formal subordination of the holdouts (as distinct from selective payment)—a breach of the pari passu covenant under a reasonably conservative reading of the clause. Because this law is unusual, this would at least limit the effect of the order on the foreign sovereign debt market. But even a narrow reading would not solve the problem raised most forcefully in the U.S. Government brief—that the injunction would give creditors a worldwide remedy beyond the scope of the Foreign Sovereign Immunities Act.

Now some might say that upholding the SDNY order, even broadly, would not be a bad thing: it would jolt a screwed-up legal regime, and might prompt sensible reform. The alternative appears to be effective impunity for sovereigns that, like Argentina, can afford to pay the nuisance tax of never-ending enforcement litigation, and bear what reputational cost it does in the markets. The argument obviously loses force with poor countries that cannot afford to stay out of the markets and live in court for a decade, and must choose between clean water and holdout creditors. Others might say that Argentina's continuing travails and the revival of pari passu as an enforcement device illustrate the cost to the international system of having no sovereign bankruptcy regime.

Few would rally behind the status quo as first best, not by a long shot. Even if the SDNY order is overturned as totally wrong (as I think it is), there is something quite dysfunctional about a market where the contracts do not map onto the background legal regime. Normal-looking clauses turn into arrant nonsense when you stick them in sovereign IOUs. This is because private debt contracts are presumptively enforceable (even if not always enforced), and can be restructured in bankruptcy. Substituting immunity for bankruptcy in the sovereign context destabilizes, and occasionally eviscerates, the meaning of the contract text.

Pari passu is the poster child for this proposition: because sovereigns cannot file for bankruptcy, there is never a moment of agreed insolvency or a waterfall of asset distribution. Instead, creditors owed on Monday might get paid, but those owed on Thursday might not. Is that subordination, or luck of the draw? The one agreed way to breach the covenant is to shout out "I subordinate"—but who does that?? (OK, maybe Argentina ... I don't think the Greek "Retro-CAC" Law is comparable.)

The biggest mystery, given such apparent dysfunction, is why the brilliant lawyers who draft sovereign debt contracts don't just fix pari passu once and for all, so that it would make sense. Smart people have offered thoughtful explanations. I suspect the answer has something to do with the dissonance of writing a totally, utterly, certainly unenforceable debt contract. That’s just not what lawyers do—or is it?

Finally, there is a weird political/PR dynamic at play here. Argentina and Greece, represented by the same law firm and threatened by the same holdout creditors, have apparently conflicting PR strategies. For Argentina, the key is to hitch its case to the European caravan, so everyone thinks that a ruling against Argentina would bring on global financial apocalypse. Hence the reference to Greece, Portugal, Spain, and Ireland as potential victims in the Argentina brief. In contrast, the last thing Greece wants is to have the spectre of Argentina hover over its still-pending debt exchange. The holdouts want some combination of both -- they want Greece to feel threatened by the potential outcome in Argentina, but not so threatened that the U.S. and the EU establishment get scared too, and join the battle full force on Argentina's side.

All this for pari passu? Stay tuned for geek party of the century.

Revised to reflect the fact that the New York Fed did not file on appeal this time. It did file in a very similar case involving the same parties in 2004. Argentina refers to this earlier position in its 2012 brief.


I am no expert in any of this, but I took at look at this mysterious NML Capital Ltd. They seem to be based in Cyprus and their prospectus looked so bland and opaque that it might have been a project by an MBA student. Yet they have the muscle and money to fight Argentina for over a decade and now Greece. Whose money do they handle? Someone who would be more comfortable knee-capping Christana than fighting her in court?
Maybe I am just paranoid....reminds me of the little houses in St. James, London, with their discreet brass plaques hiding the fortunes of the landed gentry and much worse.

NML is an offshoot of Paul Singer's Elliott Associates. http://en.wikipedia.org/wiki/Paul_Singer_(businessman) Elliott successfully used the same interpretation of the pari passu clause against Peru in 2000. That incident started the fight over the meaning of the previously obscure clause. Elliott secured an ex parte injunction from a Belgian court directing Euroclear to pay Peru's creditors pro rata. This would have diverted part of Peru's payments on its newly restructured debt to Elliott. Faced with the prospect of blowing up its restructuring, Peru settled. Elliott v. Peru is often cited as Exhibit One (some say Exhibit One and Only) for the proposition that holdout litigation disrupts sovereign debt restructuring. (Bi et al., linked in the main post, suggest this is a very very rare occurrence.) Much of the pari passu litigation history is in the briefs linked in the main post. Elliott is ever-present throughout. This WSJ post gives a sense of Elliott's other adventures, and has a link to a 2007 interview with Jay Newman, who specializes in distressed sovereign debt at Elliott.http://blogs.wsj.com/deals/2011/12/12/hedge-fund-elliott-associates-takes-vietnam-to-court/

"The biggest mystery, given such apparent dysfunction, is why the brilliant lawyers who draft sovereign debt contracts don't just fix pari passu once and for all, so that it would make sense. Smart people have offered thoughtful explanations. I suspect the answer has something to do with the dissonance of writing a totally, utterly, certainly unenforceable debt contract. That’s just not what lawyers do—or is it?"

Although there is probably an academic way to phrase this comment, I am going to keep it simple.
If one doesn't actually practice law with clients, one might have a naive view of what lawyers do. The client issuing debt has certain objectives and the priority is pretty clear. The number one is: get the money at the best price. A client issuing debt securities rarely asks, or cares, what happens if I want to restructure after I have the money. And it would be odd for the borrower to invest a lot of energy in negotiating that question. The lenders care, somewhat, but even for them the risk is remote - presumably, they would not be buying new bonds if it wasn't, although there are regulatory and political pressures to buy, I know - and the fact that the document they are looking at has the same language as the last X deals that closed is usually all they care to know. I assume they rely on portfolio diversification to address the multitude of risks in their deals. There's just a pragmatic calculation that a deal doesn't get done if every contingency is addressed de novo especially when there is not a clear legal resolution to every contingency. So it's not a reflection of intent or competence of any lawyer. Generally, the parties to the deal want it done on market terms, and they call on the lawyers to do that, no more and no less.

I guess I'll have to read the Gulati-Scott paper, but I wonder why sovereign bankruptcy isn't included by contract. Couldn't the contract say something like, "The borrower's obligations will be limited by the opportunity to enter bankruptcy in the same was as a corporation under Chapter 7, with a U.S. bankruptcy court [or an arbitrator] adapting the definition of assets as it thinks fit."

What seems to be happening is that the "big players" are buying up these types of bonds at almost bankrupt prices from the "commoners" who are scared senseless.

After all, even here in Canada, as I'm sure most of the other countries of the world, the credo to sell sovereign bonds was that "they're as safe as the sun will rise the nest day" or something to that effect.

So, the vulture capitalists are investing heavily in these bonds that they've been purchasing at low prices. Even if the sovereign countries broker a deal that is less than the vultures are asking, the vultures still stand to make a hefty profit.

Can you spell schadenfreude?

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