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Et Tu, FT? (Pari Passu Edition)

posted by Anna Gelpern

Laugh, cry, give up: the Financial Times editorial argues for Supreme Court review of Judge Griesa's decision because not enough countries use collective action clauses (CACs) in their foreign-law debt ... and recommends that all do as the Eurozone and adopt CACs (... in their domestic-law debt?). 

Aside: True, Europe had long ago promised to lead by example and adopt CACs in its foreign-law debt, but that was largely beside the point because (a) Mexico had already led by example, and (b) most European sovereign debt is domestic-law ... But maybe not for long ... Then again, the pendulum may have swung back to domestic law. For now, London looks safe from Griesa-style lurches, but so did New York until a few weeks ago.

Bottom line: for sovereign debtors and creditors alike, domestic-law debt offers protections from holdout hostage dramas like the one playing out in New York. These protections do not come from CACs, but from the debtor's unilateral capacity to change the terms (for example, to reroute the payments).  The downside for the creditors is self-evident: there is no guarantee the debtor will use this capacity for their benefit.

The FT also notes improbably that the U.S. Congress could "modify contract law to deal more sensibly with the Argentine restructuring." The idea that the federal legislature would override state law for the sake of a politically toxic debtor is pretty far-fetched, even apart from fiscal cliffside timing.

Despite all that, it is hard to disagree with the basic thrust of the editorial and the existential follow-on: "While countries should service their debts in all but exceptional cases, an orderly mechanism for sovereign restructuring is essential for the exceptions. Just as with bankrupt individuals and corporations, value is only destroyed by holding insolvent debtors in never-ending limbo. ... A sovereign bankruptcy regime is not on the horizon."

And on the bright side, at least the FT cares.


But a sovereign bankruptcy regime has been "on the horizon" since September 2001 when IMF First Deputy Managing Director Anne Krueger proposed a Sovereign Debt Restructurig Mechanism that would have effectively created a sovereign bankruptcy court under the auspices of the IMF.

Krueger's proposal was ultimately supported by 70% of the membership of the IMF. However, it was opposed and quashed by the IMF Executive Board, e.g., the creditor nations of the U.S. and Europe.

In other words, the American and European powers -- who in creating the IMF after WWII were careful to install "quota" systems that would ensure their ongoing control of the institution -- simply do not want an orderly sovereign bankruptcy process.

Instead, they prefer sovereign bankruptcies to be ad hoc and messy -- and therefore more subject to their own manipulation and control using raw economic and military power.

From their perspective, the messier Argentia's bankruptcy process, the better.

Thanks, Anna. Always great to read you. Just one comment. Although the legal technique chosen by the EU is dubious, the European CAC (ECAC) is part of a Treaty, therefore binding on all member states that signed the Treaty. This means that governments can no longer issue bonds under domestic law that contradict ECAC, and the possibility of a retroactive law like the one passed in Greece no longer exists. Arguably, this also means that governments that want to change the terms of their previously-issued bonds will need to do it through the system of majorities envisaged in the ECAC. The legal argument is clear (a minore ad maius argument): if a government can’t do the “smaller” (pass a law that allows for the possibility to change the terms of a bond through a retroactively established CAC –the Greek case-), it is also forbidden from doing the “bigger” (passing a law directly changing the terms of a bond, ignoring all participation from the bondholders). In my opinion, ECAC are poorly drafted and leave many difficult questions to be answered during the implementation stage, but they are probably better than nothing. At least to “fight” against hold-outs.

Anna, it is obvious to me that this changes the dynamics of holding out. Griesa has tried to fix in stone what was hitherto unknown. Pari passu now means BOTH equal treatment (no subordination) and pro rata. While some (eg Rodrigo Olivares Caminal) argue that Argentina is different due to the Lock law, the precedent will nonetheless be that unless pro rata payment is made to any holdouts, injunctions can prevent payments being made to any restructured debt and exchanges will fail on court based technicalities alone (I am sure NML will alter its previous attachment strategy it pursued to prevent the 2010 exchange.). It is all or nothing. Any Future restructuring (of bonds with pari passu clauses) will only take place wih huge sweeteners and even then there is an incentive to seek side payments. In other words, restructuring not allowed! It's all binary. And the coordination problem is far worse than ever before.

If NML wants to seek a payment I can buy some defaulted accelerated debt (affected by no previous judgment) and enjoin Argentina from paying until I got mine. Or just by a filing a court motion I can come along with NML.

Of course, It's easier to arrange side payments to those with bearer bonds than those with DTC or Euroclear registered bonds. So in the end the judgment has the other unfortunate consequence-it makes it better to own bearer bonds with coupon payment made by cheque or cash. And makes it far better to own English law bonds of countries which may face financial challenges from time
to time but for which continued access to capital markets remains crucial.

Ignacio: Thanks and great points about the treaty! My nagging doubts have all been about this point: "Arguably, this also means that governments that want to change the terms of their previously-issued bonds will need to do it through the system of majorities envisaged in the ECAC." Why not impose a punitive withholding tax in lieu of Retro-CACs? At a minimum, this sets up a debate about which is the smaller and which is the greater. In crisis, governments will be inclined to interpret creatively and fight the legal battles after the fact (see "no-bailout clause" controversy). That said, it is hard to argue against the proposition that some CACs are better than no CACs. The question is how much better, and at what opportunity cost for more ambitious reform.

Nickster: Many thanks. And indeed, the restructuring, documentation, and issuance incentives going forward are the heart of the matter. I think that we have only begun to think through these.

Thanks again, Anna. You are always thought provoking. Why not a punitive withholding tax? Because that would necessarily cause a higher reputational damage than a retroactive law that at least gives a supermajority of creditors a saying in the restructuring process. Besides, such tax would be difficult to implement: internally, it could face problems of constitutionality in many EU member states (problems of retroactivity, problems of breach of equality [the new taxation on public bonds would make them much less attractive, so, most probably, the member state would create the tax only for the existing bonds, entailing thereby a discriminatory treatment re future bondholders]); and externally (within the Eurozone) it could cause problems with the taxation of non-residents: the conventions on double taxation with other member states would be breached (beyond a certain percentage of retention).
In any case, there are so many obscure points concerning the effective implementation of ECAC. Especially regarding the debt issued before Jan 2013. ECAC are not applicable to pre Jan 2013 bonds, but it remains to be clarified what would happen if the debt restructuring of the old bonds was made by means of an exchange of new bonds after Jan 2013. In my opinion, the new bonds would have to incorporate ECAC. But what if the restructuring was done through a modification of the old bonds, with no bond exchange (and therefore no “new”, post Jan 2013 bonds)? You could argue that a theological interpretation of the EU Treaty that creates the mandatory ECAC would oblige the issuer to include the ECAC as part of the modifications applicable to the restructured bonds. But it is unclear. One could also use a literal interpretation of the ECAC Terms of Reference and argue that the restructured-pre Jan 2013 bonds are out of the scope of ECAC. If this were the case, one of the main purposes of ECAC (to snatch bonds away from the issuer’s ability to change the terms by passing a law) would be defeated; and the current -huge- amount of debt could be restructured over and over again...

Let's face it: Judges are not priests. If the debt was unfair in moral terms, they should protest at moral tribunals, such as churches or the UN. People invest their savings feeling safe with the US fairness and serious Judicial System. Sovereign or not, it is money. Mr. Griesa was clear and fair: Pay your debts, Argentina, no Contempt of Court, no disrespect for the judiciary. You defy the system with threats of not paying? OK, money in escrow, right away... Exemplary ruling. [email protected]

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