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Argentina’s Hundred-Year Bond and its Make-Whole Premium: A Spanner in the Works?

posted by Mitu Gulati

Argentina is on the brink of attempting a restructuring of its sovereign debt.  And, of course, that has attracted the birds of prey.  An article in Bloomberg a couple of days ago (here) reported that potential holdout creditors had hired expert lawyers to examine the fine print in Argentine contracts in the hope of finding a vehicle to support their litigation strategies.

Assuming that it is not going to be long before Argentina is in full restructuring mode, my question is whether an unusual clause in one of the Argentine bonds, combined with a recent case out of the Southern District of New York, might interfere with the Argentine government’s restructuring plans?

The clause is the Optional Redemption provision in the $2.75 bn hundred-year bond that Argentina issued in June 2017, with the hefty coupon of 7.125%.  Optional Redemption clauses, as my co authors (Amanda Dixon, Madison Whalen and Theresa Arnold) discovered in an analysis of over 500 recent sovereign and quasi sovereign issuances, are rare creatures in this market.  Fewer than 20% of all the sovereign issuers use them. Some, like Mexico, are frequent users. But others, such as Argentina, have used them only on rare occasion.

Oversimplifying, these provisions typically allow the issuer to call the bonds at a supra compensatory amount (somewhat misleadingly called the “make-whole” amount).  Our data suggests that such provisions were largely absent from the sovereign market in the period between the mid 1990s and 2010.  Somewhere around 2010 though, Issuer Call provisions with their “make-whole” premia began migrating into the sovereign world from the high-yield corporate bond market.  Precisely why the Issuer Call provisions are set at a supra compensatory amount is something of a mystery to me (Marcel Kahan and I discuss the mechanics of these clauses here).

What I’ve heard from lawyers and bankers in the interviews that Marcel and I did for our piece (here) is that high-yield corporates sometimes need to retire their old bonds to they can escape onerous covenants (for example, to engage in a lucrative merger).  And to do that they are willing to pay a high amount – that is, a supra compensatory “make-whole” premium. In the sovereign context though, not only is there not going to be any lucrative merger, but the covenants are not all that onerous such that issuers would want to pay a big premium to get out of them.  But maybe there are countries that think that their current borrowing costs are unduly high (e.g., the 7.125% coupon on Argentina’s 100-year bond) and that these costs will surely go down some day in the future.  That, in turn, will make the redemption option valuable to that optimistic issuer. And, maybe, like Argentina was in June 2017, the issuer will be willing to promise pay a high amount to creditors if conditions ever become so positive that it wants to retire substantial amounts of its high coupon debt. Alexander Hamilton certainly thought so in the Report on Public Credit in 1790 (here).  Things haven’t quite worked out for Argentina in the manner that they did for Hamilton and the US.  But a hundred years is a long time. 

Now, you might ask, why is an Optional Redemption clause relevant in the context of an attempted sovereign restructuring?  After all, an Issuer Call option and should only be relevant where the issuer chooses to exercise the option.  And Argentina is seeking to get creditors to take haircuts, rather than exercise its redemption option.  Remember, the redemption option typically requires the issuer to pay a supra compensatory amount (because it is intended to operate in a state of the world where things have improved so dramatically for that issuer that it wishes to retire the debt) – which is the opposite of the haircut that Argentina needs to impose currently (because things have turned terrible for Argentina).

The answer has to do with a New York case from late 2016, Cash America v. Wilmington Savings.  Drawing from a blog post that Marcel Kahan and I did for the Columbia Law School Blue Sky Blog a couple of days ago, here is the story of the case:

Bond indentures [for high-yield corporate issuers in the US] commonly contain what are called “make-whole” provisions that give the issuer of the bonds the option to redeem the bonds, at a premium over par. Bond indentures also contain an acceleration clause that gives bondholders the option, upon an Event of Default, to demand immediate payment of the principal amount and receive par. To reiterate, redemption is an option of the issuer while acceleration is an option for bondholders.

In Cash America [v. Wilmington Savings], the issuer was found to have violated a covenant in the bond indenture, thereby generating an Event of Default.  The court ruled that when the issuer engaged in a “voluntary” covenant breach, holders are entitled to receive as a remedy the amount they would have received upon redemption, that is a premium over the amount receivable under the acceleration clause.  [And that redemption amount was a supra compensatory “make-whole” amount].

The decision caused much consternation among numerous elite law firms. Transactional lawyers argued that the contract didn’t say anywhere, or even imply, that the bondholders were entitled to such a remedy. (For more detail on the case and the law firm responses, see here, here and here). As an aside, although we agree with the transactional lawyers that the Cash America court’s grant of the make-whole remedy to the bondholders was peculiar as a matter of contract interpretation, the court was arguably following Second Circuit precedent [the famous Sharon Steel v. Chase Manhattan case written by Judge Ralph Winter].

The implication of the foregoing, as the various law firm memos written in the wake of the Cash America case warn clients, was that bond issuers using the standard Optional Redemption provision (aka “make-whole” premium clause) should henceforth be forewarned that they might be liable for this payment if their triggering of an Event of Default sometime in the future were seen as “voluntary” by a court (see e.g., Glenn West’s blog post and this memo from White & Case).  The question to ask then is what the hell did the court in Cash America mean by the term “voluntary”.  Judge Furman’s opinion doesn’t explain. My guess is that the judge was thinking of a state of affairs where the debtor was insolvent and was being forced by the creditors into a bankruptcy proceeding.  After all, that seems somewhat involuntary. That’s not an adequate answer, but it is something.

But what about the sovereign context?  After all, sovereigns cannot be forced into a bankruptcy proceeding (there is none). Further, given that sovereigns can in theory always tax their people more to repay their debt, sovereign debt restructurings are in a sense always “voluntary”.  (Worse, sovereigns themselves frequently describe their their debt restructurings as “voluntary” – see here and here).  So, does the remedy given by the court in Cash America apply any time a sovereign (with an Optional Redemption provision) triggers an Event of Default along the way to seeking a “voluntary” debt reduction?

To conclude in the affirmative strikes me as wrong, and probably not what either of the judges in Cash America or Sharon Steel intended.  They, I think, were concerned about instances where a financially healthy issuer was trying to escape having to pay a redemption provision by causing an Event of Default and inducing creditors to accelerate and take par. And that is surely not the case with Argentina in 2020.  But I’m reading between the lines of those judicial opinions and that’s a fraught exercise.  A good litigator would not find it difficult to argue that the explicit language of the Cash America points the other way (for anyone who finds this implausible, it is worth recalling what happened in the pari passu saga). And if one reads the cases in that fashion, that then gives the holders of the hundred-year Argentine bond the basis to assert that they are owed a significantly higher amount than what other Argentine bondholders are owed.

From the Argentine perspective, that’s probably bad enough.  But the can of worms can be opened still further.  If the holders of the hundred-year bond have a plausible claim to a significantly higher payment than the other bondholders by virtue of the Optional Redemption clause in their bonds, this means that they will expect to be offered a premium over the others to get them to consent to whatever restructuring deal Argentina is offering. But if that is so, would that differential offer violate the “uniformly applicable” condition for the operation of the fancy new aggregated Collective Action Clauses in the post 2015 Argentine bonds that are supposedly going to solve the holdout problem?

The “uniformly applicable” condition requires (my emphasis) that “holders of debt securities of any series affected by that modification are invited to exchange, convert or substitute their debt securities on the same terms for (x) the same new instruments or other consideration or (y) new instruments or other consideration from an identical menu of instruments or other consideration.” The provision continues by clarifying that the uniformly applicable standard is not satisfied when bondholders are “not offered the same amount of consideration per amount of principal … as that offered to each other exchanging, converting or substituting holder of debt securities of any series affected by that modification.”

Strikes me that having to offer the holders of the hundred-year bond a special deal would violate the foregoing.  And that then means that the votes of the holders of this bond can’t be aggregated with those of the others, which in turn means that the power of the aggregated CACs to squash potential holdouts gets diminished.  And if other outstanding Argentine bonds have yet other idiosyncratic clauses that could mean that those holders also will want special deals. (Mark Weidemaier and I have talked elsewhere about the lack of clarity over what satisfying this “uniformly applicable” condition entails). 

Argentina has a history of agreeing to contract provisions that then bite it in the proverbial backside when it needs to restructure.  The infamous FRANs that Bloomberg’s Matt Levine wrote about are exhibit one (here). (Matt also has a delightful piece on the Cash America case, here).

As an aside, the Argentine century bond was issued in June 2017, over six months after the Cash America decision came down. That means that the lawyers doing the Argentine issuance would have known about the risk that the case posed for them should there need to be a restructuring.  Plus, this was not a standard boilerplate clause that the various parties might have ignored. It was a one-time use. And that means that it must have been negotiated over.  I’d love to know what the negotiation among the parties was about whether or not to put in place some corrective language to negate the implications of the Cash America decision.  In the corporate context, there were about a dozen bond issuances where such corrective language was inserted immediately after the Cash America decision came down. But investors refused to accept this corrective language after those initial dozen or so corporate deals (Marcel and I discuss this here). The sovereign context is different though, and the downside risks posed by the Cash America decision are arguably larger.

Comments

Argentina is clearly on a tight spot, no need emphasizing that. I think the best strategy would be to avoid Cash America to be applicable. If this outcome is possible, then there would be no need to discuss whether there is a violation of the Uniformly Applicable Conditions, because there would be no risk of 100 yr bondholders of demanding a higher compensation. Argentina should take the necessary steps to have bondholders represent prior or within a restructuring process that the restructuring is not an "event of default" as comparable to that in Cash America, should they wish to receive an offer of restructuring. This is the only way out, because choosing to discuss the applicability or not of the Uniform Conditions already has a negative track record.

It seems to me that there is at least some difference between the situation in Cash America and the one in Argentina, thus allowing us to avoid applying the decision to Argentina restructuring process. The event of default in Cash America was triggered by spinning off a major subsidiary, which had resulting in a covenant default. It is arguably more like an intentional choice (if not a bad faith one) than a situation where a sovereign simply cannot pay its debt. It is true that a sovereign can always tax their people more to repay their debt, but is it always doable and plausible? There could be lots of other factors to take into account, such as political ramifications. In other words, a sovereign debt restructuring might not always be as voluntary as it seems like, and thus probably not the same as the situation in Cash America.

I do not think Argentina's hundred year bond holders would be willing to invoke this "voluntary" default claim, though as in other comments I do not believe this is a voluntary default, especially not one that is tailored to circumvent the redemption clause. As the basic logic in sovereign debt restructuring is accepting debt relief in exchange of collectability, either these bond holders will agree that a corrective language is inserted, or as Francisco said Cash America will be totally ignored. No party would be happy to leave the table with disagreement. Actually these bond holders need to agree for a second reason; redemption clauses are usually unattractive for investors because if they are paid before maturity they would probably reinvest at a lower rate. In exchange of this risk, these bonds are offered a higher interest rate. Investors should have agreed to lend with this in mind. Then, wouldn't it be an explicit bad faith to use this clause to be treated in a more beneficial way than other creditors?

Argentina’s first order of business should be finding a new law firm that doesn’t agree to conflicting lending terms that lead to holdouts and lawsuits. In the event of a restructuring, the creditors would be wise to highlight the fact the clause had been negotiated for, evidently to address Cash America. Argentina’s response will be, as the blogpost notes, that the kind of voluntary default in Cash isn’t the same as a sovereign trying to restructure. A country’s infinite life and lack of shareholders should be a sufficient distinction from Cash to permit restructuring, although a court could very reasonably disagree.

I agree with the above that the Cash America decision can probably be differentiated here. However, in the unfortunate case that Argentina will get stuck with these potential holdouts, it seems like they still have options. This scenario brings to mind Windstream’s nearly successful attempt to circumvent Aurelius’ breach of covenant claims in 2019. Could Argentina hold an exchange offer whereby bondholders could join an add-on of the June 2017 bonds and simultaneously vote to remove the Optional Redemption provision? Perhaps incentivized by the “hefty coupon” or by a >1:1 exchange ratio. If they simply got more bonds in exchange, they could still be paid on par with other bondholders (in compliance with the Collective Action Clauses). I am also curious why and how these provisions were added in the first place, as they seem so unlikely to prove beneficial for Argentina.

For Cash America to interfere, the holders of the hundred-year bonds would have to argue they are entitled to a higher payment than the other bondholders because, in the absence of the restructuring, they would be entitled to a higher payment than the other bondholders. The problem is, they wouldn’t. In Cash America, it was the “voluntary” nature of the debtor’s actions that led the court to order specific performance of the “make-whole” provision. While Judge Furman doesn’t give a detailed explanation of what “voluntary” means, he does provide an example of an “involuntary” action—bankruptcy. So, too, does Judge Winter in Sharon Steel—“a case in which a debtor finds itself unable to make required payments.” But a restructuring of Argentine debt, almost by definition, would occur only under circumstances in which Argentina were unable to service its debt (either currently or in the foreseeable future). Why else would bondholders agree? So, if and when a restructuring occurs, a court would likely conclude Argentina’s actions were involuntary; as Brenda notes above, it simply could not pay its debt.

Randall Kroszner argues that asymmetric debt forgiveness can create “unnecessary chaos rather than renewed growth.” Therefore, even if Argentina avoids the “uniformly applicable” condition, it may still suffer by having to pay holdout hundred-year bondholders a significant premium over other bondholders. And if Argentina cannot avoid the “uniformly applicable” condition, it may be forced to both (1) make whole the hundred-year bondholders and (2) make whole the other creditors. Argentina’s best hope is to successfully argue that its event of default is not voluntary--but since it has taxation power, that argument seems dubious.

I agree that the sovereign context is different than the corporate one in this situation, and thus I would like to think that a (reasonable) judge would consider Argentina's potential restructuring as involuntary given the likely devastating implications of applying Cash America to the Argentine case. However, I do worry that an overly formalistic judge who blindly looks at the Cash America precedent would regard Argentina's restructuring as voluntary. I think that not including a provision that protects against the Cash America risks was a mistake, and hopefully Argentina doesn’t pay for it.

This has the makings of another cautionary tale courtesy of Argentina. Especially for a country that has defaulted eight times in its history, and has already restructured in the new millennium, sovereigns need to plan for the possibility of future restructuring when making debt offerings. Of course, if tying your hands in the future can secure more favorable financing, and avoid the need to restructure at all, then that’s something else to consider. But that’s not the case here. Since the clause was negotiated for, I’m wondering what Argentina got out of it? It certainly wasn’t a good interest rate.

I agree with the previous posts that present the difference between a voluntary default committed by a corporation and that of a sovereign. However, I question would be, even if the Cash America decision becomes relevant to Argintina's resturcturing, what would happen? Argintina probabaly would not be able to pay the super-compensatory make-whole payment anyway if that does kick in. Could it be certain creditors believe that they can get something out of Argintina from this.

I find the post Cash America negotiation of the redemption clause very curious. Presumably this is a clause that Argentina would have requested; unless creditors negotiated its inclusion, being aware of the potential Cash America ramifications if Argentina sought a restructuring at some point in the future, which seems unlikely. In any case, it feels like an optimism-driven blunder. As the author, and previous commenters have pointed out, Argentina will have to distinguish its circumstances from the Cash America/ Sharon Steel situation. The genuine need for a restructuring and the innate differences of the sovereign setting may be enough to distinguish, though it seems far from certain.

I agree with Daniel and Brenda’s points that a sovereign debt restructuring might not be considered voluntary. The decision to engage in restructuring rather than just default on repayment may be a voluntary one, but a country entering a situation where it must choose between one of those two options is not a voluntary decision. If Argentina’s economy improved and it realized it could issue new debt at a lower coupon payment, then a choice to default on its 2017 hundred year bonds (triggering acceleration) looks like a scenario in which the choice was made voluntarily to avoid paying the redemption premium—analogous to the Cash America. I (or perhaps a better lawyer if Argentina can afford one) would argue that the country has no real alternative than to reduce its debt burden and should not be punished for restructuring and providing some repayment to creditors instead of not paying at all.

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