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Do Judgements Trump CACs?

posted by Mitu Gulati

(Thanks to Steven Bodzin of REDD Intelligence for flagging this matter; he has an aptly titled piece on this out today “Venezuela Bondholders Seek Judgement Ahead of Collective Action Clause Activation”).

A few weeks ago, I put up a post on the what I thought was an interesting and innovative set of arguments being raised by Juan Guaido’s team in the Casa Express/Pharo Gaia v. Venezuela litigation in New York (here).  I was especially interested in the argument that an obscure customary international law doctrine of necessity (i.e., things are really really bad in my country, so I can’t pay just yet) justified the court granting a stay in the litigation.  This argument was tried in a series of arbitral proceedings under bilateral investment treaties by Argentina in the wake of its 2001 crisis and it had mixed success.  But it has never before been raised in a New York court, under a garden variety New York law governed contract.  So, the judge will have to decide whether this international law defense is even admissible in this context or whether the only excuse defenses allowable are those from New York contract law (e.g., impracticability, duress, unconscionability, etc.). And then, assuming the judge rules in the affirmative, the question will be whether the necessity defense applies in this context. 

At the end of last week, the creditors submitted their counter arguments.  As expected, they expressed outrage and shock that the debtor would seek to bring in a defense from the outlandish world of customary international law into their precious New York law contract dispute arena.  But buried in between the outrage was a point that may well open pandora’s box. 

On page 5 of the creditor submission, in explaining why the grant of a stay would harm them and, therefore, should not be granted, the creditors say:

[The] threat [of prejudice to the creditors’ ability to recover] is magnified here by the collective-action-clauses in the 7.75% 2019 bonds which allow a supermajority to bind nonconsenting creditors to the terms of restructured bonds. . . . A judgment would protect the Pharo Plaintiffs who hold beneficial interests in the 7.75% 2019 bonds – from such compulsory restructuring of their debts. (emphasis mine).

The last sentence is worth reading again.

The context here is important.  For the better part of two decades the hopes and dreams of the official sector for an orderly sovereign debt workout mechanism (i.e., quashing those pesky holdouts who try to disrupt restructurings) have resided, pretty much exclusively, in the widespread use of collective action clauses (CACs) in sovereign bonds (see here, here and here).  A concern, all through this period, however, has been that clever holdouts will figure out some loophole to bypass the CACs.

Now, is Pharo really telling us that they’ve figured out a breathtakingly simple strategy to bypass the entire CAC edifice?  Yup. If I’m reading the brief correctly, Pharo is saying that once it has obtained a court judgment on its bond, it is immediately liberated from the prospect of being compelled to accept a negotiated settlement through activation of the CAC in that bond. Aiyiyiyi.

The folks at the various Official Sector institutions who spent years and years designing and selling these CACs as the solution to global sovereign debt crises must be beside themselves. (from a personal point of view, this may mean that the half dozen or more academic papers that I’ve written on the wonders of CACs may need to be tossed in the rubbish heap).

Of course, things are more complicated than that.  At issue here is a doctrine known as "merger".   The theory is that once a claim has been reduced to a court judgment, the plaintiff's claims under the contract are "merged" into the judgment. Thereafter, the plaintiff can enforce only its judgment, not the underlying contract. In other words, the underlying contract loses its legal vitality; it falls away like a booster on a space rocket. This, I think, is the theory of the plaintiffs in the Pharo/Casa Express case.   Once they secure a judgment, they are no longer subject to the CAC in the old bonds. 

The foregoing is not crazy. With the caveat that civil procedure was the class I liked the least in law school – it seemed singularly lacking in a logical structure and full of unnecessary uses of latin phrases like res judicataand confusing doctrines like Erie --  my impression is that plaintiff’s understanding of the merger doctrine is one that is shared by many in the legal community.

Based on my limited knowledge of the caselaw, I think, however, that there may be a barrier to this clever strategy to slip the knot of the CAC.  In recent sovereign debt litigation, at least two federal judges in New York have held that the issuance of a judgment does not extinguish the underlying contract; it merely lifts from that contract the specific claim asserted in the plaintiff's lawsuit and prevents any relitigation of the merits of that specific claim. As I read what those courts did, the other rights and obligations contained in the underlying contract retain a measure of legal vitality and can be exhumed and enforced under the correct circumstances. 

The judges were Harold Baer and Thomas Griesa, both cases were at the trial court level, and both cases both involved my favorite clause, pari passu. In other words, this is obscure stuff.  The cases were Ex-Im Bank of Rep. of China v. Grenada No. 13-CV-1450 (S.D.N.Y. Aug. 19, 2013) and NML v. Argentina No. 14-CV-08630 (S.D.N.Y. Jun. 5, 2015).  In both, the judges held that the pari passu clause in a sovereign bond did not die or become inoperative merely by virtue of the fact that the claim for payment under the bond had been reduced to a court judgment.   Indeed, Judge Griesa allowed holders of judgments against Argentina to reach back into their old bonds, dust off and assert as a new claim an alleged breach of the pari passu clause in those bonds. Argentina argued that the doctrine of merger precluded this selective reanimation of a clause in debt instruments that had been reduced to court judgments.  Judge Griesa disagreed and gave the judgment holders the benefit of a pari passu injunction, just like the bondholders that had not yet received a judgment on their bonds. 

If the doctrine of merger does not extinguish all rights and obligations contained in the underlying contract, a bondholder's promise to abide by a decision of a supermajority of its fellow creditors on the restructuring of the obligation -- the collective action clause -- may not be extinguished when a judgment is rendered in respect of that bond.   The undertaking to abide by a supermajority decision is, after all, not just a promise to the issuer of the bond, it is equally a promise to all fellow holders of the bond. 

The addition of this new twist in the case has significantly raised the stakes and could potentially push the US Treasury Department to step in and file its own brief. The USG has been trying to stay out of the Venezuelan litigation, perhaps to avoid antagonizing already irate Wall Street investors who hate the sanctions regime.  But CACs are in part a creation of the US Treasury.  If they are at risk, maybe the Treasury will be forced to speak?  And if so, this is going to be a fun hearing to attend.

My friends who do not share my enthusiasm for big sovereign debt legal battles will probably point out that I’m getting my hopes up unnecessarily. After all, the Pharo court does not need to rule on the CAC viability question. The issue was raised by the plaintiffs only as an example of the injury they might suffer if they are delayed in their ability to obtain a quick judgment.   But with the Guaido administration unable because of US sanctions to proceed with a comprehensive debt restructuring, the chances increase every week that holders of defaulted bonds will obtain court judgments before a debt restructuring can be completed.  Whether such judgments forever liberate the bondholders from the covenants they undertook when they bought the bonds is, therefore, soon going to be ripe for judicial decision.

This little case, that I thought just last week was about an obscure customary international law doctrine, might well end up being one of the most consequential in the world of sovereign debt.

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