I have to give it to Reynolds Holding on this one: he called it, I was wrong, and today I paid him $5 in settlement of our bet. To the astonishment of almost everybody I know (except Ren), the Second Circuit sided with Elliott Associates and ruled unanimously against Argentina today. It’s a hugely important decision, which will certainly have unintended consequences for many years to come.

You can see the market reaction most clearly in Argentina’s credit default swaps, which gapped out to a whopping 1,325bp. That’s up 350bp on the day, and it’s a clear sign that the markets are extremely worried the unexpected ruling will cause the very thing it’s ostensibly trying to cure: an Argentine default.

This isn’t the end of the story — but it is the beginning of the end. Argentina is making noises about appeals, but at this point it’s not obvious that higher courts will even accept the case. And while it’s true that the Second Circuit did end up punting on the one bit of the original ruling which actually had teeth, all of their language implies that they’ll ultimately uphold it.

Here’s the problem facing the US courts. Everybody agrees — even Argentina is happy to agree to this — that Argentina owes Elliott Associates lots of money. Everybody agrees that Argentina has a contractual obligation, under New York law, to pay lots of money, to Elliott, right now if not sooner. But of course Argentina has made no such payment. And so it’s very easy for Elliott to go to a New York judge (in this case, Thomas Griesa), and get that judge to hand down a judgment telling Argentina in no uncertain terms that it owes Elliott lots of money. And Argentina will in turn treat that judgment with exactly the same respect it gives to the original bond contract. In fact, for tactical reasons, Elliott has chosen not to become a judgment creditor: if it just had a court judgment, and not a bond contract, then it would find it much harder to argue arcane legal points about various bits of legal boilerplate in the contract.

Which is why, in February, Griesa came up with an order which carried much more force than a simple judgment. The order comes with a real punch:

Within three (3) days of the issuance of this ORDER, the Republic shall provide copies of this ORDER to all parties involved, directly or indirectly, in advising upon, preparing, processing, or facilitating any payment on the Exchange Bonds (collectively, “Agents and Participants”), with a copy to counsel for NML. Such Agents and Participants shall be bound by the terms of this ORDER as provided by Rule 65(d)(2) and prohibited from aiding and abetting any violation of this ORDER, including any further violation by the Republic of its obligations under Paragraph 1(c) of the FAA, such as any effort to make payments under the terms of the Exchange Bonds without also concurrently or in advance making a Ratable Payment to NML.

This is very cunning stuff. Remember that Argentina is happily current on its outstanding bonds: what that means in practice is that every time a coupon payment is due, it pays that money to the bondholders’ Trustee, Bank of New York, which in turn divvies it up between all the current bondholders. As you might guess from its name, Bank of New York is very much under the jurisdiction of New York courts. And Griesa, with this order, is taking aim directly at Bank of New York. If Argentina tries to pay its existing bondholders without at the same time paying Elliott Associates and the other holdouts, then Bank of New York will be aiding and abetting a violation of his order. And there’s no way it wants to do that.

The problem here, from a legal perspective, is that once Bank of New York has the money, the money belongs to bondholders, not to Argentina. And so it’s difficult for Griesa to tell the bank it’s not allowed to remit the money to the bondholders who have every legal right to it.

In terms of the meat of Griesa’s order, it’s this part about “aiding and abetting” which really gave Elliott hope that it might finally be able to collect on what it was owed. And, just to drag things out a bit longer, that’s the one bit of the order that the Second Circuit felt uncomfortable about:

We do have concerns about the Injunctions’ application to banks acting as pure intermediaries in the process of sending money from Argentina to the holders of the Exchange Bonds. Under Article 4-A of the U.C.C., intermediary banks, which have no obligations to any party with whom they do not deal directly, are not subject to injunctions relating to payment orders… Oral argument and, to an extent, the briefs revealed some confusion as to how the challenged order will apply to third parties generally. Consequently, we believe the district court should more precisely determine the third parties to which the Injunctions will apply before we can decide whether the Injunctions’ application to them is reasonable.

This gives a sliver of hope to Argentina — but only a sliver. The Second Circuit remanded the case back down to Griesa to clarify his order a bit, and they’re really only asking for clarification rather than evisceration. The whole point of the order is that it includes US actors as well as Argentina itself, and there’s no way that Griesa will reword things so that Bank of New York is suddenly magically excluded.

Once Griesa’s clarification makes its way back to the Second Circuit, the judges there have made it abundantly clear that they’re well-disposed towards the lower-court judge, and very ill disposed towards Argentina. As JP Morgan’s Vladimir Werning says of the request for clarification: “While this may generate a perception that the Appeals Court can change its mind if the District Court clarifications do not satisfy it, we doubt this is likely to happen.”

I’m sure that Argentina and its lawyers have been working for a while on contingency plans which they could put in place were the Second Circuit to uphold the lower court’s decision: those plans have now taken on extra urgency, but it’s really not obvious what Argentina can do, especially if it wants to avoid yet another event of default. There’s paying off the holdouts, of course, but that would be politically incredibly dangerous, and it’s hard to imagine Cristina Kirchner ever signing off on such a thing. She might not be the world’s most principled politician, but her hatred for Elliott and the holdouts is real. And as Werning’s excellent note says, none of the alternatives are particularly appealing — or particularly likely to avoid the countries CDSs being triggered.

Argentina does have time — a fair amount of time, too, if this ends up being successfully appealed to the Supreme Court. After all, the US government argued on Argentina’s side; I’m no lawyer, but I’ve got to imagine that SCOTUS tends to at least hear the cases which would otherwise go against the government’s wishes.

What’s more, the Second Circuit has given the Supreme Court an interesting third option: rather than completely upholding the original order, or striking down completely, the Supremes could basically go just as far as the Second Circuit did today, and then ultimately reject the extra step of including Bank of New York and/or other blameless intermediaries.

I don’t think that will happen, however: in many ways it would represent the worst of both worlds. It would still be a huge change to international law, and would amount to a very significant weakening of the Foreign Sovereign Immunities Act . The US government, in other words, would suffer a massive loss. And at the same time it would in practice let Argentina off the hook — and no one has much sympathy for Argentina here, a country which has been thumbing its nose at the US courts for years.

So the base-case scenario at this point has to be that Elliott will ultimately win. I can hardly believe I’m writing these words: I’ve been writing about holdouts, or vultures, or whatever you want to call them, for a good dozen years now, and although they’ve had victories here and there, there’s been nothing remotely as big or precedent-setting as this. When push comes to shove, governments make laws, and the official sector is generally good at closing ranks and making sure that sovereign rights and immunities are protected.

Except, that doesn’t seem to be the case any more. The part of the Second Circuit’s argument dealing with sovereign immunity is probably the weakest bit, but the court certainly doesn’t pay much if any deference to the United States and its arguments here:

The Injunctions at issue here are not barred by § 1609. They do not attach, arrest, or execute upon any property. They direct Argentina to comply with its contractual obligations not to alter the rank of its payment obligations. They affect Argentina’s property only incidentally to the extent that the order prohibits Argentina from transferring money to some bondholders and not others. The Injunctions can be complied with without the court’s ever exercising dominion over sovereign property. For example, Argentina can pay all amounts owed to its exchange bondholders provided it does the same for its defaulted bondholders. Or it can decide to make partial payments to its exchange bondholders as long as it pays a proportionate amount to holders of the defaulted bonds. Neither of these options would violate the Injunctions. The Injunctions do not require Argentina to pay any bondholder any amount of money; nor do they limit the other uses to which Argentina may put its fiscal reserves. In other words, the Injunctions do not transfer any dominion or control over sovereign property to the court. Accordingly, the district court’s Injunctions do not violate § 1609.

A lot of the oral arguments surrounded this point, and it seemed, to me at least, that Argentina’s side was much more convincing. It’s true that “the Injunctions do not require Argentina to pay any bondholder any amount of money”, but if Argentina wants to stay current on its bonds — and that’s a perfectly reasonable thing to want to do — then they absolutely do require Argentina to pay holdout creditors at the same time. Which seems like an override of Argentina’s sovereign will to me. Conversely, if Argentina chooses not to pay the holdouts, it will be in the odd position that it can do anything it wants with its money — it is a sovereign nation, after all — except give it to the very creditors it made a solemn promise to pay in 2005 and 2010.

The result is a very weird and scary world, for all sovereigns, including the US — and for the markets, too. Sometimes, markets are secretly cheering the vultures: after all, the more money vultures make, the healthier the bid for bonds when countries tumble towards default. But in this case, the decision is clearly bad for markets. For one thing, by emboldening holdouts, it makes future sovereign debt restructurings much more difficult. (The Second Circuit tries to say that it doesn’t, thanks to something called Collective Action Clauses, but as Anna Gelpern says, that argument doesn’t hold water.)

More broadly, this ruling is just one more step towards a world where the old verities about sovereign risk simply don’t hold any more. It used to be that sovereigns were sovereign: that was bad news if they unilaterally decided to default on you, but other than that it was pretty good news. Now, however, they’re at the mercy not only of unelected technocrats at places like the IMF or the ECB; they’re also at the mercy of unelected judges in New York. Sovereigns have less freedom of movement now than they have done in a very long time, and we’re only beginning to grok the implications of those constraints.

As far as Argentina is concerned, it might just have to pay the holdouts. No one knows how much money that might entail spending: the figures range from $1.3 billion at the low end (large, but manageable) to $12 billion at the high end. That would cause real economic damage. Again, Werning is good on this. And whether or not Argentina pays the holdouts, the risk of a credit event in the CDS market are seriously high right now: there’s a hundred ways that things could go wrong and the CDS could get triggered. In fact, this being Argentina, it’s entirely possible that the government could deliberately trigger the CDS, after various important people had loaded up on protection.

The upshot is a significant rise in uncertainty, in an asset class which could really do without such a thing right now. The Second Circuit’s narrow and constructivist view of some long-ignored legal boilerplate could end up having very profound effects on global markets and economics. Maybe that’s what the letter of the law demanded. But I sure wish it didn’t.