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Don't Fix It, Call It a Risk Factor! (Updated)

posted by Anna Gelpern

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.


Mrs. Gelpern,
you state that "the Second Circuit has said pretty clear that pari passu means pro rata payment".I am unable to find that in the 10/26 ruling by the court. To quote the Court;" Thus, the parties’ dispute over the meaning of the Equal
Treatment Provision presents a “simple question of contract interpretation.”
Argentina argues that the Pari Passu
Clause is a boilerplate provision that, in the sovereign context, “has been universally understood for over 50 years . . . to provide protection from legal subordination
or other discriminatory legal ranking
by preventing the creation of legal priorities
by the sovereign in favor of creditors holding par
ticular classes of debt.”
We are unpersuaded that the clause has this well settled meaning. Argentina’s selective recitation of context-specific quotations from arguably biased commentators and institutions notwithstanding, the preferred construction of
pari passu clauses in the sovereign
debt context is far from “general, uniform and unvarying,” Please explain, why you seem to propose that there is just one and only one meaning for all the different wordings prescribing the status of a creditor in respect to other creditors of the same debtor.

Mr. Manthey: Thank you for your comment. I am having trouble understanding where we disagree (let alone where I say "one and only"). I do not believe there is any disagreement on the point that the Second Circuit settled the interpretation of Argentina's contract on October 26, leaving only the remedy up for further elaboration on remand. Hence the separate en banc procedure.

Mrs. Gelpern: I have to apologize to have misread your comments of 2/21. For my understanding a sentence like "the Second Circuirt has said pretty clear that pari passu means pro rata payment" is not equivalent with a sentence like " the Second Circuit has said pretty clear that the specific pari passu clause used in the FAA of Argentina means pro rata payment".
I had the same point in a discussion with Joseph
Cotterill when I commented on his article " Present at the creation, pari passu edition (FTAlphaville, 1/25),

your referral to Tether's "origin" story is interesting, but irrelevant to the order of the Second Circuit of Oct. 26, which explicitly does not delve into the intentions of the participants of the drafting of the Fiscal Agency Agreement (FAA) of Argentina, but refers to the meaning of the wording ( order page 16"the parties' dispute over the meaning ... represents a 'simple question of contract interpretation' ").

Let me comment on your following sentence:" If the pari passu clause is a ratable payments clause, then that makes it inherently an intercreditor clause." The implication you deduce is conditional on the correctness of the condition and if the condition does not exist you say nothing about what follows.
The Second Circuit does not argue that " the pari passu clause is a ratable payment clause", but
takes the results of research done by Buchheit, Gulati and Choi, which show that the different
phrasing of what is conveniently called "pari passu clause" do not boil down to a coherent
prescription ( page 17, " We are unpersuaded that the clause has this well settled meaning").
In the opinion of the court, the specific clause in the FAA in respect to the prescribed treatment of different creditors of the same class of External Debt has two sentences with different meanings: The first sentence is a prescription for Argentina as an issuer of debt to avoid issuing External Indebtedness that is legally considered to be superior to debt issued under the FAA. The second sentence is a prescription for Argentina as a payor not to pay other bonds without paying the FAA bonds (page 18).

If you as well as others insist to talk about the pari passu clause as a "piece of boilerplate" you should tackle the description of the Second Circuit that the clauses, referring to the treatment of a creditor in respect to other creditors of External Debt, has a great deal of variance and can not be reduced to one meaning. The correct way to falsify that view of the court is to show that its description is wrong by demonstrating that all different wordings in different indentures come down the the same prescription.

My experience is summed up by Richard A. Samp in his Jan. 23. piece in The National Law Journal: " Critics are not taking into account the unique aspects of the pari passu clause in the FAA bonds that are at issue in this case. This clause requires "equal" treatment for all bondholders. Such specific language is uncommon in most sovereign debt documents."

Kind regards

Rainer Manthey"

If you will use in the discussion around
Argentina a broad contention to designate a specific incident, I will adopt to your use of words.
Kind regards

Rainer Manthey

Mrs. Gelpern: please let me correct my last sentence to make it intelligible.
If in the future, discussing Argentina's equal treatment/pari passu clause, you will use a broad phrase like "the pari passu clause means" to talk about a specific case ( the pari passu clause in the FAA of Argentina) I will adapt to your way of using words.

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