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1) What is the role played by legal clauses such as the collective action clause and the pari passu clause in sovereign debt issuances? 2

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1) What is the role played by legal clauses such as the collective action clause and the pari passu clause in sovereign debt issuances?

2.What is the difference between a typical hedge fund investing in sovereign debt (even distressed sovereign debt) and the so-called vulture funds?

3.If you were appointed a mediator by the court to find a solution, what options or alternatives would you suggest for resolving the crisis?

Chapter 8 Mini Case Argentina and the Vulture Funds Mini-Case: Argentina and the Vulture Funds Argentina’s default on its foreign currency denominated sovereign debt in 2001 had proved to be a never-ending nightmare. Now, in June 2014, 13 years after the default, the U.S. Supreme Court had confirmed a lowercourt ruling, which would force Argentina to consider defaulting on its international debt obligations once again. But the story was a tangled one, which included investors all over the world, international financial law, courts in New York State and the European Union, and a battle between hedge funds and so-called vulture funds—funds that purchased distressed sovereign debt at low prices and then pursued full repayment through litigation. Time was running out. 8-2 © 2016 Pearson Education, Inc. All rights reserved. Argentina and the Vulture Funds: The Default • • • • • • 8-3 Argentina’s currency and economy had nearly collapsed in 1999. The rising sovereign debt obligations of the Argentine government, debt denominated in U.S. dollars and European euros, could not be serviced by the faltering economy. In late December 2001, Argentina officially defaulted on its foreign debt: $81.8 billion in private debt, $6.3 billion to the Paris Club; and $9.5 billion to the International Monetary Fund (IMF). The debt had been originally issued in 1994 and registered under New York State governing law. New York law was specifically chosen because Argentina had become known as a serial defaulter. The bonds were issued under a specific structure, a Fiscal Agency Agreement (hence FAA Bonds), which would require all debt service be made through escrow accounts in New York. The normal process following default is for the debtor to enter into talks with its creditors to restructure its debt obligations. Reaching consensus on sovereign debt restructuring, however, may be difficult because there is no international statutory regime for sovereign default similar to domestic bankruptcy codes. This leaves three options: (1) a collective solution; or (2) a voluntary exchange of old debt for restructured obligations; or (3) litigation. The first option, the collective solution, is usually accomplished via the use of collective action clauses (CCAs) that impose similar reorganization terms on all creditors once a specific percentage of creditors, 75% to 90%, have agreed to the restructuring terms. These CCAs prevent a small number of creditors—holdouts—from blocking restructuring. Unfortunately, the Argentine bonds did not have collective action clauses. Given the absence of a collective action clause, Argentina was left with the second option, a voluntary exchange of old debt for new debt © 2016 Pearson Education, Inc. All rights reserved. Exhibit A Argentine Sovereign Bond Price and Default 8-4 © 2016 Pearson Education, Inc. All rights reserved. Argentina and the Vulture Funds: The Default • Debt restructuring itself normally includes four key elements: • The total result is a reduction in the net present value of the debt obligation, the so-called haircut, which may range anywhere from 30% to 70%. A second common clause included within sovereign debt, the pari passu clause (Latin for “equal steps,” and is read as “equal among equals”), calls for all creditors to be treated equally, assuring that private or individual deals are not made in reference to some creditors over others. Argentina’s sovereign debt did include a pari passu clause (Argentine Fiscal Agency Agreement (1994), Clause 1c): • • 1) 2) 3) 4) a reduction in the principal of the obligation; a reduction in the interest rate; an extension of the obligation’s maturity; and capitalization of missed interest payments. ? “The Securities will constitute [. . .] direct, unconditional, unsecured and unsubordinated obligations of the Republic and shall at all times rank pari passu and without any preference among themselves. 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 (as defined in this Agreement).” 8-5 © 2016 Pearson Education, Inc. All rights reserved. Exhibit B The Terms of the 2010 Argentina Bond Exchange 8-6 © 2016 Pearson Education, Inc. All rights reserved. Argentina and the Vulture Funds: Restructuring • • • • • • • 8-7 Following the December 2001 default, Argentina initiated restructuring discussions with its creditors. From the very beginning it took a hard line. Nearly every dimension of the proposed restructuring was in debate, but the 70% haircut Argentina proposed was the single biggest problem. What followed, as seen in Exhibit A, was a long and twisted path toward debt resolution. It is important to note that many buyers of these bonds in the secondary markets were not original investors—they were intentionally buying defaulted debt. After three years of contentious talks and two unsuccessful proposals, Argentina moved forward with a unilateral reorganization offer to all creditors in early 2005. In preparation for the offer, Argentina passed the Lock Law, Ley cerrojo. The Lock Law prohibited Argentina from making any arrangement to pay the unexchanged bonds: “The national State shall be prohibited from conducting any type of in-court, out-of-court or private settlement with respect to the FAA [Fiscal Agency Agreement] bonds.” The Lock Law was meant to provide additional incentive for all creditors to exchange old debt for new debt—immediately. Characterized as a “take it or leave it” offer, creditors were offered 26% to 30% of the net present value of the original face value of bond obligations, and as a result of the Lock Law, a one-time only offer. The offer was accepted by 75% of Argentina’s creditors, reducing outstanding private debt from $81.8 billion to $18.6 billion. The offer was executed by exchanging the original bonds for new Argentina bonds. The following year Argentina repaid the $9.5 billion in debt owed to the IMF. In 2010, in an attempt to eliminate the remaining outstanding private debt, Argentina temporarily suspended the Lock Law to allow the same bond exchange terms be offered once again to private debt holders. This second offer reduced the outstanding private debt principal to $8.6 billion. A full 92% of all original creditors had now exchanged the original debt for the reduced value new debt instruments. © 2016 Pearson Education, Inc. All rights reserved. Argentina and the Vulture Funds: Dueling Hedge Funds • • • • • Distressed sovereign debt is not a rarity, and so it is not surprising that a number of hedge funds have made the buying and selling of publicly traded distressed debt a business line. There was, however, a fundamental difference between hedge fund investing in corporate distressed debt and sovereign distressed debt. A fund purchasing a substantial portion of distressed corporate debt may become integrally involved in turning around the company; that was not the case with distressed sovereign debt. Gramercy. One sovereign debt investor of note was Gramercy. In Gramercy’s promotion of its distressed debt fund shown in Exhibit C, it highlighted its investments in the debt of Argentina. Note that the stated target return greatly exceeds the yield to maturity (the rate of return expected by a prospective investor at issuance who holds the security to maturity). The higher target return is based on the highly discounted purchase price of the securities relative to what Gramercy hopes/expects to sell the securities at a future date. Gramercy reportedly held $400 million in Argentine bonds in 2012 and still in 2014. In addition to its purchase of distressed sovereign debt, Gramercy also aggressively protected its investments on the downside through the use of credit default swaps (CDSs). The credit default swap is a derivative contract that derives its value from the credit quality and performance of any specific asset. – – 8-8 A CDS is a way to bet whether a specific security would either fail to pay on time or fail to pay at all. In some cases it provided insurance against the possibility that a borrower might not pay. In other instances, it was a way in which a speculator could bet against the increasingly risky security. This was a result of the fact that, as opposed to traditional insurance where an owner of the asset purchased insurance for their asset, an investor in CDSs need not own the asset (like your neighbor purchasing fire insurance on your house). © 2016 Pearson Education, Inc. All rights reserved. Exhibit C Gramercy’s Holdings of Argentine Debt 8-9 © 2016 Pearson Education, Inc. All rights reserved. Argentina and the Vulture Funds: Dueling Hedge Funds • • • • • • • • • 8-10 Gramercy’s Chief Investment Officer was Robert Koenigsberger, formerly the manager of the sovereign debt restructuring team at Lehman Brothers. Koenigsberger had acted as an advisor to Argentina in its arguments in U.S. and European courts. It was in fact Gramercy that had persuaded Argentina to reopen the 2005 restructuring negotiations in 2010. As Gramercy championed the 2010 restructuring offering, it argued that the markets were mis-pricing Argentine debt on the basis of government debt as percentage of GDP. Argentina’s credit default swap (CDS) spread was a full 700 basis points—7.00%—above U.S. Treasuries, although Argentina’s debt/GDP ratio was a moderate 46.4%. At the same time Brazil had a CDS spread of 119 basis points with a 61.7% debt/GDP ratio, and Turkey a 150 basis point CDS spread with a 49.0% debt/GDP ratio. If Gramercy was correct, and if the market “corrected its error,” the prices of the Argentine bonds would rise dramatically. Elliot. A second hedge fund, Elliot Management Corp, had waged war on Argentina and its debt for years. Elliot, led by Paul Singer, a 68-year-old billionaire and a high-profile supporter of the U.S. Republican Party, was one of the chief litigants against Argentina. Singer had been called the father of vulture funds, and had used this same investment strategy in Peru, the Democratic Republic of Congo, and Panama, in recent years. Elliot’s fund, NML Capital Ltd., had first invested in Argentine bonds before the 2001 default, but had purchased most of its holdings as late as 2008, in the midst of the global financial crisis, at rock-bottom prices. (One story reported that Elliot paid $48.7 million for $832 million in bonds, $0.06 on the dollar.) It now claimed it was due $2.5 billion. As the lead holdout, Elliot had refused the offered exchange in 2005 or 2010. Elliot was known for hard-knuckle tactics, actually having detained an Argentine naval training vessel, the ARA Libertad, in a Ghanaian port for more than two months in an attempt to attach collateral. © 2016 Pearson Education, Inc. All rights reserved. NML Ltd. v Republic of Argentina • Because the distressed debt was under the jurisdiction of New York State law, specifically the Fiscal Agency Agreement (FAA), the case was eventually heard in U.S. District Court. The FAA stipulated that the repayments on the bonds were to be made by Argentina through a trustee based in New York, giving U.S. courts jurisdiction. On October 25, 2012, Judge Thomas P. Griesa for the United States District Court for the Southern District of New York, in NML Capital, Ltd. v. The Republic of Argentina, found in favor of the plaintiff: . . . the judgements of the district court (1) granting summary judgement to plaintiffs on their claims for breach of the Equal Treatment Provision and (2) ordering Argentina to make “Ratable Payments” to plaintiffs concurrent with or in advance of its payments to holders of the 2005 and 2010 restructured debt are affirmed. • The impact of the court’s decision was dramatic. Argentina immediately announced that it would not honor the court’s decision. One month later Argentina lost its [first] appeal, with Judge Griesa instructing Argentina to move forward quickly to comply with the Court’s judgement. • Again, Argentina refused to comply. Fitch, one of the three major global sovereign credit rating services, now downgraded Argentina’s credit rating (long-term foreign currency) from B to CC, noted that “a default by Argentina is probable.” • The markets closely followed the case. As illustrated by Exhibit D, the value of the outstanding Argentine exchange bonds plummeted in the days and months following the rulings. For example, the Argentine 2017 Global Bond (exchange bond from 2005) carrying an 8.75% coupon fell 9.9% in the one day following the court judgement, and a cumulative 24% in the following week. • In subsequent hearings Judge Griesa cautioned Argentina on altering the payment processes on the bonds. This was in response to Argentina’s newest strategy to circumvent the U.S. courts by processing payments to the exchanged bondholders through financial institutions outside the United States. The FAA bonds and their governing law expressly required processing through New York financial institutions. 8-11 © 2016 Pearson Education, Inc. All rights reserved. Exhibit D District Court Ruling Impact on Exchange Bond Values 8-12 © 2016 Pearson Education, Inc. All rights reserved. NML Ltd. v Republic of Argentina • On appeal Argentina argued that the District Court had misconstrued the pari passu clause, but the Second Circuit court was not persuaded. • The court noted that the combination of the issuance and service on the exchange bonds, without making equal payments to the holdouts, and simultaneously stating under the Lock Law that the holdouts would not ever be paid, was in effect ranking or subordinating the original debt. The court went on to note the particularly critical role the pari passu clause plays: When sovereigns default they do not enter bankruptcy proceedings where the legal rank of debt determines the order in which creditors will be paid. Instead, sovereigns can choose for themselves the order in which creditors will be paid. In this context, the [Pari Passu Clause] prevents Argentina as payor from discriminating against the FAA bonds in favor of other unsubordinated, foreign bonds. • To its credit, Argentina had made substantial efforts at repairing its relationship with the outside world. In late May it had committed to repaying the $9.7 billion owed the Paris Club, and had agreed to pay Repsol of Spain, $5 billion in Argentine bonds for its seizure of its Argentine subsidiary earlier in 2013. • On Monday June 25, 2014, Argentina deposited $832 million in a New York bank in preparation for payment of interest on its exchange bonds. This would be in direct conflict with the ruling of the courts. According to Argentina’s economic minister: “Complying with a ruling doesn’t exempt us from honouring our obligations. Argentina will meet its obligations, will pay its debt, will honour its promises.” • A full-page official communique was placed in the Financial Times explaining the country’s position. But the court order prevented the banks from dispensing payments on the restructured debt unless holdout creditors were also paid. Argentina argued that because it had deposited the money in the transfer accounts for payment, the bondholders had been paid. • The courts disagreed. 8-13 © 2016 Pearson Education, Inc. All rights reserved. What Now? • • • • • • 8-14 Argentina’s response to the latest U.S. court rulings was outrage. Within days Argentina announced a plan to swap existing bonds governed by U.S. law for debt issued under Argentine law. Although unprecedented in sovereign debt markets, the move had been anticipated by market analysts. If investors were willing to undertake the exchange they would receive some of the highest interest yields in the world—foregoing default—but they would give up all legal rights and protection provided under U.S. law. Judge Griesa released a statement that any attempt by Argentina to proceed with payments on its restructured debt, without settling with holdouts first, was illegal. Argentina continued to argue that this was impossible. According to the Argentine Finance Minister, if Argentina settled with the holdouts, the exchange bondholders could possibly sue for equal treatment—the RUFO clause (Rights Upon Future Offer), and total claims could reach $120 billion. The RUFO clause, contained in all of the exchange bonds issued in 2005 and 2010, guaranteed exchange bondholders the same rights and payments that might possibly be provided the holdout bondholders. Given the renewed currency crises the country was currently suffering, Argentina’s hard currency reserves were estimated at only $30 billion, inadequate to threaten invoking RUFO interests. On June 30, 2014, Argentina failed to make payments on its outstanding exchange bonds. The country now had a single 30-day grace period before entering into selective default. In early July, representatives of the Argentine Finance Ministry and the Elliot Group met to see if they could find an acceptable solution. © 2016 Pearson Education, Inc. All rights reserved. Argentina and the Vulture Funds: Case Questions 1. What is the role played by legal clauses such as the collective action clause and the pari passu clause in sovereign debt issuances? 2. What is the difference between a typical hedge fund investing in sovereign debt (even distressed sovereign debt) and the so-called vulture funds? 3. If you were appointed a mediator by the court to find a solution, what options or alternatives would you suggest for resolving the crisis?