Why Are Creditors OK With The Province of Buenos Aires’ Dodgy Use of Exit Amendments?

Mitu Gulati and Mark Weidemaier

For the most part, the financial press has not scrutinized the details of the ongoing restructuring by the Province of Buenos Aires (PBA), which is nearing completion. The details are worth considering. Some aspects of the exchange offer might have crossed the line between good and bad faith and might have been subject to legal challenge. But this turns out be an uncertain area of law.

The basic transaction is structured as an exit exchange, and this technique raises some legal uncertainties even if we ignore the dodgy particulars of PBA’s restructuring. A debtor in financial distress needs to negotiate a debt reduction with its creditors. The debt contracts allow creditors to consent to reduce the amounts owed them, but only on condition that a majority or supermajority vote in favor. Let’s say, hypothetically, this requires the support of 90% of creditors. And let us say that the debtor has managed to persuade only 60% of creditors to support its restructuring proposal. So the debtor would seem to be out of luck.

Enter the exit exchange.

Although the debt contracts require 90% creditor approval to modify payment terms, they allow other terms to be modified with lesser support (say, 50%). So the debtor, along with the 60% of supporting creditors, sets up the exit exchange. It offers everyone a new bond with restructured financial terms, which creditors may accept in exchange for their outstanding bonds. To participate, creditors must also vote to modify the old bonds, typically by stripping them of key legal protections (non-financial terms that are subject only to a 50% voting threshold). If the prospect of these changes is sufficiently threatening, few creditors will want to risk being stuck holding the old bonds. The fear generates pressure to participate in the restructuring.

This does not violate any explicit term of the debt contracts, but it smells funny. Creditors are voting to modify instruments they no longer plan to hold; the entire purpose of the vote is to modify other people’s rights. Arguably, the whole process denies non-participating creditors the benefit of their bargain. After all, didn’t they expect that the bond’s payment terms could be restructured only with 90% creditor support? And if only 60% of creditors support the restructuring's payment terms, but the exit exchange amendments coerce higher participation, hasn’t the whole process been an end run around the 90% voting threshold?

Scenarios like this implicate the doctrine of good faith and fair dealing that applies to all contracts. The doctrine is generally understood as a tool to constrain contracting parties from taking actions—again, not specifically forbidden by the contract—that effectively deny a counterparty the benefit of its bargain. Although there have been lawsuits raising the duty of good faith in the context of an exit exchange, the technique has repeatedly been upheld. (Perhaps the most famous case is Katz v. Oak Industries.) When courts uphold a debtor’s use of the exit exchange, they generally reason that the technique was needed to address a creditor-side collective action problem. In other words, the deal was a good one for creditors as a group, and the exit exchange was needed to prevent a small group of holdout creditors from extracting a disproportionate recovery.

This logic makes a fair amount of sense, but it’s also somewhat perplexing. Didn’t creditors bargain ex ante for the right to make a restructuring difficult or impossible? Some might object to the content of this bargain—for example, in this context, because it transfers too much of the costs of a sovereign’s fiscal adjustment onto the populace. But that isn’t the logic of the cases. The logic, in effect, is that the ex post interest of a creditor majority in accepting a restructuring proposal trumps the ex ante agreement to make restructuring difficult. We think this outcome makes some sense, but we don’t fully understand the logic supporting it. Nevertheless, one implication is that an exit exchange becomes problematic when it is unduly coercive. That is, if the creditor majority exists only because of the fear generated by the threatened amendments, any argument for the use of the technique falls away.

Back to PBA. The Province’s bonds have collective action clauses (CACs). Oversimplifying, these provisions allow for the debtor, with supermajority support (say 75%), to force restructured payment terms on a dissenting creditor minority. Before 2003, sovereign bonds issued under New York law typically allowed each individual creditor to accept or reject a restructuring proposal; no one could be bound by the restructuring without their assent. CACs like those in the PBA bonds were adopted after 2003 to fix the perceived deficiencies of this regime. Creditors didn’t like having their lunch eaten by holdout creditors, so they agreed to add a collectively-binding restructuring mechanism to bonds issued under New York law. But in return, they wanted sovereigns to back off on using the exit exchange.

Mechanically, contracts tried to achieve both objectives through two changes. First, provisions requiring unanimous consent to the modification of payment terms were replaced by CACs allowing a creditor supermajority to modify these and other so-called “Reserved Matters.” Second, the list of Reserved Matters was expanded to include many important non-financial terms (such as the governing law clause and the waiver of sovereign immunity) that might otherwise be targeted for modification in an exit exchange. The expectation was that the new contracts would channel restructuring proposals into the supermajority voting mechanism provided by the CAC.

That… is not what has happened in the PBA restructuring. Instead, the Province’s lawyers dug through the contract for less “important” provisions that had not been added to the Reserve Matter list in the 2003-04 deal between creditors and debtors. And they combined these provisions into something very scary for creditors. Presumably, they did this because the PBA did not have the supermajority support it needed to trigger the CAC voting threshold. Whether the restructuring proposal had the support of a clear majority is a separate question.

So, what was the scary change? It was the threat to change the place of payment on the bonds. At first cut, this might not seem important. But of course, even a passing knowledge of the risk of capital controls should make investors nervous. In fact, there is even more to be nervous about. The offering documents for the exit exchange spell it out quite clearly. The excerpts below are from the Risk Factors section of the offering document filed with the SEC (the language in the Offer doc is in italics):

In the event that the Province amends the place of payment under the 2006 Indenture Eligible Bonds to Argentina, the Province may select any financial institution or entity in Argentina to act as paying agent and such financial institution or entity need not be an agent of the trustee.

So, the threat is not simply to change the place of payment to somewhere in Argentina but also to let the PBA select the institution to receive the money. This institution, the Offer doc threatens, is not going to be an agent of the trustee. So the contract’s terms governing “place of payment” include not just the physical location but the identity of the institution? Could it be the grocery store around the corner from the Ministry of Finance in Buenos Aires? A little scary, but also puzzling. Why?

In any such case, any payments by the Province pursuant to the 2006 Indenture Eligible Bonds shall be subject to any restrictions set forth by the Central Bank or other regulatory entity in Argentina, at the time of each such payment.

Oh, yes. That’s right. The little corner store is also subject to the dictates of the Argentine Central Bank.

… holders of the 2006 Indenture Eligible Bonds that are not individuals may face certain restrictions to transfer outside of Argentina any amounts they receive in foreign currency (U.S. dollars or euros) under the 2006 Indenture Eligible Bonds via a cross-border bank wire transfer. No assurance can be given regarding the restrictions on transfers of funds that may exist in the future.

Yup. The central bank might just impose capital controls or, perhaps worse, require a forced exchange into Argentine pesos at some locally-determined exchange rate. The Argentine Central Bank has a habit of imposing such controls. Given the close political connection between the government of the Province of Buenos Aires and the Argentine government, the threat is now fully visible.

These are not just serious threats; they are threats that directly implicate the value of the payment term. And that, at least arguably, do an end run around the higher voting threshold that supposedly protects amendments to payment terms. Now, there are cases involving corporate bonds—notably, the 2d Circuit’s Marblegate case—that let issuers get away with similar things. These cases aren’t directly applicable here—Marblegate is a case under the Trust Indenture Act, not the duty of good faith—but they do suggest courts are willing to give issuers significant leeway here. Yet, there must be some limits on the ability to coerce participation in an exit exchange. Whatever those limits are, the PBA may be pushing them.

Why have creditors tolerated this? Some possibilities that have been suggested to us include:

1. The financial terms of this deal are pretty good for the creditors, so the threats aren’t viewed as important. But then why make them? Why incur the ire of those who are concerned about the bad precedent? Was there political value to seeming to be all tough with the creditors? If so, why—especially if we acknowledge that the creditors got generous payment terms?
2. Maybe the creditors were not able to act fast enough to put together a group that could effectively fight these strategies. We’ve seen this in the past.
3. Good faith is simply not a robust doctrine in this context. Although it does more work in other contracting contexts, courts treat bonds as if they were “complete” contracts that fully and efficiently addressed all future contingencies. So if the contract does not literally forbid something, it is allowed. As a descriptive matter, this has some merit. Courts do seem especially formalist when interpreting financial contracts. But cases like this may highlight the limitations of that approach.

We confess that we aren’t really sure of the answers. We plan to investigate further in upcoming conversations on our Clauses and Controversies podcast. Upcoming episodes include Scott Squires of Bloomberg, who has done some of the best reporting on the PBA shenanigans, and Professors Dave Hoffman and Tess Wilkinson-Ryan (Penn; the Promises, Promises podcast), who we hope can help us better understand the role and limits of the duty of good faith and fair dealing.

Comments

[Ben Heller]

Great piece, Mark. I can actually answer some of these questions. Will also note that making "Place of Payment" a reserve matter was my idea way back when the new model bond documents were drafted. I view this use of exit consents to modify it on pre-2014 bonds either as an insult or a compliment. Not sure which, though!

It is definitely the case that there was not enough time to "sue on a matter of principle." I think most people were OK with the economics on this offer, so these abusive terms weren't even necessary. One big reason there was not enough time to sue was that it seemed to us that we needed to go through the Trustee and there was no way to jump through the hoops to get the Trustee to act in less than months. This calls attention to the fact that we need an agent other than the traditional trustee to handle these matters if we (individual bondholders) are to forfeit our right to easily sue directly.

And a move that was at least as coercive as the exit consents was the way PBA exploited the fact that the decision to say "yes/no" to a deal and the decision of what bond to pick off the menu are not separated. If you vote no, you don't get to pick. PBA stuck non-pickers with terrible bonds. It seems this is in direct conflict with the one-limb language at the very least (creditors must get same instrument or choicec of menu of instrument -- there is no choice). This gambit jammed no-voters for something like 13 points. This is clearly an abusive attempt to create a prisoners' dilemma.