Harry Campbell

Foreclose on a country?

It sounds far-fetched, but a United States court is saying that Argentina must set aside $1.33 billion for some American hedge funds and others. That decision is threatening to throw the South American country and the entire sovereign debt market into turmoil.

This game of chicken is a lesson on the hazards of United States courts’ interfering in international affairs.

The origins of the mess arise from Argentina’s status as a sometime deadbeat debtor. In 2001, the country defaulted on more than $80 billion worth of sovereign bonds. Historically, a default like this leaves bondholders with few options. There is no global bankruptcy process and individuals can’t force a country to pay. A century or so ago, creditor countries would sometimes send in gunboats and troops to force payment.

These days, the lawyers and bankers are sent in, as a default usually leads to a restructuring of the country’s debt. Typically, the creditors are forced to take a haircut while the country pays something to try to maintain access to the global credit markets.

This is what happened in Argentina. In 2005 and 2010, Argentina restructured its debt offering to exchange the old bonds for new bonds at the paltry sum of 25 to 29 cents on the dollar. Argentina was able to push bondholders to accept such a low price because the offer was coupled with a new law passed by its Legislature making it illegal for the country to pay the old bonds. In other words, it was either the new bonds or nothing.

But there were holdouts, including thousands of Italian pensioners, who own what is now about $11 billion in debt.

The holdouts also included a number of hedge funds, some of which had acquired this debt as far back as the 1990s, seeing an opportunity for a big return, despite the risk. The group also includes Elliott Management and Aurelius Capital Management.

Elliott, a $20 billion hedge fund founded by Paul Singer, is one of the leaders in this field. It previously made outsize returns investing in defaulted sovereign debt and trying to force the country to pay by seizing its assets. For about $2 million, for example, Elliott bought sovereign debt with a face value of more than $30 million that was issued by the Republic of Congo. The fund was able to win a $100 million judgment in England and intercept $39 million worth of oil owned by the Republic of Congo. In the case of Argentina, Elliott recently was able to get a Ghanaian court to order the seizure of an Argentine frigate.

While the standoff over the frigate is embarrassing for Argentina, it is a sideshow to the litigation by Elliott and Aurelius in New York

A few years ago, Elliott and Aurelius changed their legal tack. They argued in court that the pari passu clause in the bond documents — common language in such documents that says that the investors cannot be treated differently — required that if Argentina paid any money on its new bonds it also had to pay the old defaulted holders. “Pari passu” is a Latin phrase that roughly means “on equal footing.” It is intended to ensure that if a debtor issues new debt, it cannot be superior to the old debt.

Argentina showed up in Federal Distric Court for the Southern District of New York and through its lawyers heatedly argued that these clauses merely required Argentina to treat bondholders legally the same, not make equal payments, as the funds argued.

It’s an arcane legal argument, and most legal scholars and those in the market sided with Argentina, stating that this was how debt restructuring had worked for decades.

But in October, the United States Court of Appeals for the Second Circuit disrupted this precedent, siding with the hedge funds. The court held that the pari passu clause required Argentina to pay the hedge funds on the old debt any time it made a payment on the new debt.

Argentina has a $3 billion payment on its new bonds due on Dec. 15. Last week, Judge Thomas P. Griesa of Federal District Court piggybacked on the Court of Appeals decision, ordering that if Argentina made this payment, it and any third parties through which this money was transferred would also have to set aside $1.33 billion, the entire amount owed to the hedge funds, to pay the old debt equally.

It’s now chaos. Many believe that Argentina will simply default on all of its debt, refusing to pay the new debt to avoid paying the hedge funds — which have been deemed “vultures” by the country’s politicians.

Hernán Lorenzino, Argentina’s economy minister, reacted angrily to the court decisions, saying that they were “a kind of legal colonialism” and that all “we need now is for Griesa to send us the Fifth Fleet.”

The uncertainty has affected Argentina’s capital markets. Its stock market fell on the news, and credit-default swaps on Argentine debt have skyrocketed in price as the markets worry about yet another Argentine default.

Elliott and Aurelius are no doubt giddy. The current bondholders are wondering how they got dragged into this dispute.

This decision will also have real effects on global finance. Most bonds issued by sovereigns contain pari passu clauses, and this type of exchange was par for the course for country debt restructuring. (Just think of Greece.) And while bonds have changed in recent years to accommodate workouts and may be under the laws of different countries, it is still unclear whether these circumstances will affect the Court of Appeals ruling, as Anna Gelpern, a noted scholar in this area, has written. The ability of a country to achieve a workout and avoid this type of guerrilla action just got harder and more uncertain at a time of debt restructuring in Europe.

This is not supposed to happen.

The Foreign Sovereign Immunities Act of 1976, which exempts sovereign nations from litigation, was enacted to avoid this. It prevents United States courts from attaching the property of foreign countries, a reason you don’t see American creditors seizing Argentine frigates in New York harbor. But in the suit by Elliott and Aurelius, the courts sidestepped this act by ruling that their decision reflected how Argentina should act, without requiring it to pay. If Argentina decides not to pay the new debt, it does not have to pay the old debt. Still, the spirit of the act seems violated. And it is bad news when United States judges are seen as controlling the destinies of foreign countries.

Argentina is no angel. It is deliberately avoiding repaying these bondholders, and it used its sovereign immunity to force a disadvantageous situation. And the country is busy nationalizing other assets, including the energy company YPF, signaling increasingly that it is a bad global citizen.

But the Federal District Court overseeing this case through a decade of tiring litigation seems more focused on cramped legal interpretations and the morality of debt than on the wider consequences of its rulings. The judge in the matter even called Argentina’s actions “immoral” — whatever that means to hedge funds and to other investors in a world of finance where only numbers matter.

And the federal courts willfully entered into this quicksand, overturning decades of custom and practice in these deals. For a few federal judges to take such an extreme step and upset the entire debt market, not just Argentina’s capital markets, seems a bit risky.

The next move belongs to Argentina, which is entering another court appeal. But whatever happens on appeal, it is unlikely that the country will pay the hedge funds anytime soon, meaning that this battle between the federal courts and the country is likely to intensify. What a mess.