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Lebanon’s Unusual Pari Passu Clause and the Question of How to Construct Credible Priority

posted by Mitu Gulati

A few weeks ago, Mark Weidemaier and I blogged about Lebanon’s unusual pari passu clause and Collective Action Clauses. The question we were interested in – and the one our students are focused on – was how to engineer a restructuring that would be protected against the risk of holdout creditors (here).  One of the few methods available, assuming that creditors were likely to have blocking positions in a number of the Lebanese foreign law bonds, was to utilize Lebanon’s unusual pari passu clause to do an Exit Exchange.  Yesterday, one of the students in my debt restructuring class, who is working on designing a plan for Lebanon, posed the following inconvenient questions: Isn’t this clause internally inconsistent, with the second half of the clause contradicting the first half?  And if so, won’t a court disregard the second half as a scrivener’s error?

The student has a point. It isn’t obvious from the text of the clause, but there is an argument to be made that the second half of the clause contradicts the first half.

Let us take the clause that Mark and I excerpted. I’m going to break it into two parts, the traditional bit and Lebanon’s unique spin.

Part I says:

The Notes constitute direct, general, unconditional, unsubordinated and . . . unsecured obligations of the Republic which rank pari passu in priority of payment, without any preference among themselves and at least pari passu with all other present and future unsecured and . . . unsubordinated Indebtedness of the Republic, . . .

Part II says:

. . . other than any Indebtedness preferred by Lebanese law

 

The first part of this clause “The Notes . . . rank pari passu in priority of payment . . .“ is classic pari passulanguage. Until the infamous Elliott v. Peru and NML v. Argentina cases, there wasn’t much thought given to this clause in the sovereign world (for the pari passu saga, see here). It was an old clause that got repeated by rote in deal after deal without anyone really understanding what it meant.  After the Elliott v. Peru case, where Elliott Associates won a big victory against Peru by asserting a novel understanding of the clause and getting a judge in Brussels to buy that understanding, a number of scholars and practitioners set about attempting to figure out what the clause actually meant.  The most famous and widely cited of the many papers that were written is, unsurprisingly, by the guru of sovereign debt, Lee Buchheit (along with collaborator, Jeremy Pam) (here). 

To cut a long story short, Lee and Jeremy dig through the historical record and find evidence that what the clause originally aimed to protect against was the practice from the days of yore where sovereigns would sometimes pass domestic laws promising one set of creditors priority over other creditors.

If Lee and Jeremy are correct – and I’m fairly sure that theirs is the dominant understanding of the clause in the market – then the portion of the clause highlighted in bold above (Part II), that says that Lebanon can pass a domestic law favoring some creditors over others, makes no sense.  The reason being that it contradicts the first part of the clause that says that Lebanon may not make any laws favoring some creditors over others. That is, Part I of the clause says X (you may not make a law favoring some creditors over the others), and Part II says not X (you may indeed make a law favoring some creditors over others).

How is this possible? There are a couple of possibilities. First, maybe Lee and Jeremy were wrong in their explanation of the function of the pari passu clause.  Second, maybe that bolded portion of the clause (the contradictory Part II) got inadvertently copied from a corporate bond indenture (an exception for priorities created by the domestic law of the sovereign does make sense in a corporate bond, but not so much in a sovereign bond).*

From conversations with veteran sovereign debt lawyers and from my prior research with Steve Choi and Bob Scott, I’m inclined to think that the second explanation is more plausible.  But I can’t prove it conclusively (for the empirical study with Bob and Steve suggesting some of these extra bits of language in pari passu clauses are random mutations, see here).

That then takes us to:  Could Lebanon’s restructuring lawyers still use that bolded language (Part II) -- that seems to say that Lebanon passing a domestic law to grant some creditors priority over others would notviolate the pari passu clause – to its advantage in trying to engineer a restructuring?  I suspect so. The Buchheit and Pam theory of what the clause means is probably right, and may be what all the gurus of sovereign debt believe to be correct, but it is hard to imagine a New York court digging into all of that.  Most likely, the court will see that the clause explicitly allows Lebanon to pass laws to bypass its equal ranking promise to the creditors and that’s what they will allow. End of story. But it sure does seem a very strange outcome.

From the restructurer’s point of view though, there is one more hurdle to cross. And that is to design a priority promise (using Part II of the Lebanese language) that is credible to the market.  The question of how to do this is one that the gurus of the sovereign world have been puzzling through in the context of the design of Corona bonds (see Chris Spink’s excellent article that appeared today, describing a recent zoom discussion among some of the luminaries of the sovereign debt world, including Lee Buchheit, Ugo Panizza, Jeromin Zettelmeyer, Giampaolo Galli, Robin Wigglesworth, Colby Smith, Anna Szymanski and others about how to make this work). This is a tough nut to crack, since these governmental promises of priority are often not viewed by the markets as especially credible (see here).

* Quite apart from the point in the text above, most pari passu clauses promise equal ranking with other senior "Indebtedness" -- a term that is usually defined to mean money borrowed and deferred purchase price of goods and services. The categories of senior debt established by law and enforced through bankruptcy codes (taxes, unfunded pension liabilities, etc) are therefore not "Indebtedness". Another reason that the Lebanese clause is something of a platypus.

Comments

To modify a contract using the scrivener's error doctrine, "the party seeking reformation [must] establish [through] evidence that is clear, precise, convincing and of the most satisfactory character that a mistake has occurred and that the mistake does not reflect the intent of the parties." Young v. Verizon's Bell Atlantic Cash Balance Plan, 667 F. Supp. 2d 850, 894 (N.D. Ill. 2009).

This is a very high bar for potential holdout creditors.

Lebanon should fight tooth-and-nail to establish that Part II reflects the intent of the parties. And even if Lebanon cannot establish this, it can hopefully sow enough doubt for a court to hold that the creditors did not prove a mistake by "the most satisfactory character."

Perhaps the contradiction disappears if the pari passu clause is read as saying that the Republic shall not de facto subordinate the old debt (i.e. stop paying the bondholders of the bonds if it pays out on any subsequent issues) unless it subordinates them de jure? (Ironically, NML might have a salutary effect here!).

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