Disarming Holdouts in Sovereign Debt Restructurings

The pari passu litigation against Argentina—discussed extensively here on Credit Slips, on FT Alphaville, and elsewhere—caused many people to worry that future government debt restructurings would become more difficult. Some have their eye on Venezuela as the next to default, though the country and its troubled state-owned oil producer PDVSA stubbornly continue to pay external creditors despite dire economic and humanitarian circumstances. Wherever the next crisis occurs, there will be interest in devising ways to avoid the fate that befell Argentina.

A quick re-cap: federal courts in New York (i) interpreted the pari passu clause in Argentina’s contracts to forbid the country to keep current on its restructured debt unless it also paid holdout creditors in full and (ii) implemented this ruling through an injunction preventing financial and other intermediaries from helping Argentina continue making payments. Some worry that this remedy, if widely applied, could make it impossible to restructure.

So…what to do? Here’s a new proposal from Lee Buchheit (Cleary Gottlieb) and Mitu Gulati (Duke). It’s cute. And it has a clever name: the Cryonic Solution.

Buchheit and Gulati propose that restructuring participants exchange non-performing Old Bonds for New Bonds. But rather than cancel the Old Bonds, as is typical, the sovereign will give them to a trustee. The trustee won’t sue to enforce them, but it will be instructed to pass along anything it happens to receive on the Old Bonds to holders of New Bonds. Post-restructuring, the government would have two plans. Let’s call them Plan A and Plan B.

• Plan A is what typically follows a debt restructuring implemented through an exchange offer. The government simply pays holders of New Bonds and stiffs holders of Old Bonds.

• Now assume a court concludes, as happened with Argentina, that such payments violate the pari passu clause because the government is paying its obligations under the New Bonds in full (i.e., a coupon payment) without making an equivalent payment under the Old Bonds (i.e., full payment of all principal and accrued interest). The court enjoins any payments that do not treat equally-ranked bondholders equally. So the government turns to Plan B.

• In Plan B, the government stops paying on the New Bonds. Instead, it makes a payment to all holders of Old Bonds, including holdouts. But it doesn’t pay the full amount due under those (long-since-defaulted) bonds. Instead, it pays only enough to channel to holders of New Bonds the amount they are presently owed under those instruments.

• If the court looks askance at these payments, the government argues that Plan B complies with the injunction by treating each holder of Old Bonds equally (and no less favorably than any other pari passu-ranking creditor).

As I said, it’s cute. As Matt Levine aptly puts it, the plan “weaponizes the concept of fairness that lies behind the pari passu clause.” Robin Wigglesworth calls it a way to “turn the pari passu weapon back on any holdout creditors.” Readers of this blog will also recognize, I hope, that the Cryonic Solution depends entirely on the willingness of courts to respect form over substance, and that’s what I want to talk about.

From the perspective of a court that has entered (or is willing to enter) a pari passu injunction, Plan B is permissible only if it represents a partial payment to all holders of Old Bonds, rather than a disguised, full payment of amounts due under the New Bonds. Again, this is because a government that makes a full coupon payment on the New Bonds can treat holders of Old Bonds equally only by paying their much larger claims in full. Plan B does funnel some money to holdouts, but it is only a small portion of what they are owed.

Functionally, there are plenty of reasons to view Plan B as a disguised, full payment to holders of New Bonds. After all, it's Plan B! The original plan, which the government presumably followed right up to the point it was enjoined, was to stiff holdouts entirely while paying restructured New Bonds in full in accordance with their terms. Now the government is stiffing holdouts a little less while transferring the same amount as before into the pockets of investors holding New Bonds. True, the payments get to their pockets via a different route, but why does that matter to the outcome?

To be clear, I’m not saying that a court would necessarily reject Plan B as a violation of the pari passu clause or any injunction enforcing it. What I am saying is that Plans A and B are economically indistinguishable from the perspective of holders of New Bonds. To hold that Plan A contradicts the pari passu clause while Plan B does not is to respect form over substance. That is a plausible outcome, but it is not the only one.

Here’s where I wonder whether the Cryonic Solution, however ingenious, has much work to do. To see why, understand that the pari passu injunction is an inherently discretionary remedy. One reason is that there is interpretive wiggle room in assigning meaning to the clause. As Buchheit and Gulati point out, the Second Circuit didn’t make clear whether discriminatory payments alone violate the pari passu clause in the absence of other aggravating factors (such as Argentina’s passage of a statute forbidding payments to or negotiations with holdouts). But questions of contract interpretation are not where a trial judge has maximum discretion, for appellate courts typically review such questions de novo. The real source of discretion lies in the power to fashion an appropriate remedy. And trial judges have significant discretion in deciding whether an injunction is the appropriate remedy for breach of contract.

This post is already long enough, and I don’t want to bore readers with a treatise on injunctive remedies, so I’ll just say this: If a judge thinks an Argentina-style injunction would be ill-advised, she can easily avoid granting one by employing traditional legal methods that are substantially insulated from appellate review. In Venezuela’s case, for instance, a judge could cite the country’s dire economic and humanitarian circumstances as ground for refusing injunctive relief. Even if economic and humanitarian conditions improve, there will remain equitable grounds for denying injunctive relief—unclean hands, laches, a determination that the costs of the injunction to the government or to third parties outweigh the benefits to holdout creditors, etc.

Once it is understood that the trial judge's decision to grant injunctive relief is discretionary and insulated from review, it becomes clear that the Cryonic Solution only matters in cases where the judge is willing to enter a pari passu injunction despite having the discretion not to do so. But I struggle to see why such a judge, having approved injunctive relief, would then interpret the pari passu clause to authorize the payments contemplated by Plan B. After all, that decision would immediately render the injunction irrelevant. Moreover, that decision, unlike one denying injunctive relief, would likely be subject to de novo review on appeal.

Again, this isn’t to say the Cryonic Solution is a bad idea. It gives the government another argument against the entry or enforcement of an injunction. The problem is that the kind of judge who thinks it appropriate to enter a pari passu injunction seems especially likely to reject that argument. Meanwhile, a judge who thinks an injunction inappropriate doesn't need the Cryonic Solution to justify denying that remedy.

Perhaps Buchheit and Gulati worry that courts will view the pari passu injunction as a creditor entitlement—that is, that a judge otherwise inclined to rule in the government’s favor will feel obliged to issue an injunction anyway. For such a judge, the Cryonic Solution would offer an alternative route to the desired result. But the notion that judges might feel obliged to grant injunctive relief seems implausible. Sure, courts commonly award injunctive relief (at least in the US) in some disputes, such as those involving ownership of real property. But it beggars belief to think that courts will come to view injunctive relief against foreign governments as routine. If I’m right about that, the Cryonic Solution may prove a solution in search of a problem. Perhaps it will be used in a future restructuring in which courts deny holdout creditors the right to block debt payments. But even if that happens, I suspect the result will say more about the presiding judge than about the true need for a Cryonic Solution.

Comments

[Dave T]

Interesting take. I think that this idea also has broader practical problems.

Even if it "works" for existing debt, it may not solve the issue of market access for future debt issues. For example, Argentina's parri passu clause says "the payment obligations of the Republic under the Securities shall at all times rank at least equally with all its other present and future unsecured and unsubordinated External Indebtedness." So there's still the problem of how payments on future debt interact with amounts due on defaulted, unexchnaged bonds.

There's also the fact that a large face amount of old debt exists, even in the hands of a friendly trustee. There's a fine line here of saying "yes, this debt is a legal obligation of our country" but "no, we won't in fact ever legally have to pay it". There has to be at least some chance that other bondholders, the IMF, analysts, etc. decide that they need to focus on the first point and not the second in assessing the country's future debt burden.

I also wonder if this treatment has negative tax consequences for the exchange bondholders. In a "clean" exchange, they've given up their old bonds and gotten new ones with 50% of the face value (and a stated interest rate on that amount). They've taken a loss, but at least it's clear that they have a capital loss for tax purposes. Under this revised structure, however, isn't there a case to be made by foreign tax authorities that these bondholders still have the right to the full principal amount (and the ongoing stated interest on that amount) through the trustee? Meaning that the bondholders haven't yet realized a capital loss for tax purposes, and may also need to continue to accrue a much higher amount of interest for tax purposes.

[Mark Weidemaier]

Interesting point. If the cryonic solution works, it may only insulate bonds that are effectively "secured" through holdings of Old Bonds, and that doesn't include post-restructuring debt issues. As for the tax law issues, I plead ignorance...!

[Christopher]

Discussed on an elementary level (explaining the "holdout" issue via viewers who cheat the system at drive-in theatres) at AllAboutAlpha:http://www.allaboutalpha.com/blog/2016/09/01/sovereign-debt-a-cryonic-solution-to-the-holdout-problem/