[Editor's Note: This article is a continuation of yesterday's post.]
Ripple Effects in Restructuring Sovereign Debt:
Although the ruling in NML Capital v. Argentina only binds the Second Circuit, the sovereign debt market will feel the ripples of the district court and Second Circuit’s rulings, especially because of New York’s prominence as a financial center and because many sovereign debt contracts are governed by New York law. The exact effects of the courts’ decisions are hard to discern until the dust settles. For instance, following the courts’ decisions, bond issuers have included a warning of the uncertainty surrounding the meaning and interpretation of the pari passu clause in bond offering brochures. Paraguay, one of many sovereigns to include warnings in its offering information, has notified investors of the following:
“In ongoing litigation in federal courts in New York captioned NML Capital, LTD. v. Republic of Argentina, the U.S. Court of Appeals for the Second Circuit has ruled that ranking clause in bonds issued by Argentina prevents Argentina from making payments in respect of the bonds unless it makes pro rata payments in respect of defaulted debt that ranks pari passu with the performing bonds. The judgment has been appealed.
“We cannot predict when or in what form a final appellate decisions will be granted. Depending on the scope of the final decision, a final decision what requires ratable payments could potentially hinder or impede future sovereign debt restructuring and distress debt management unless sovereign issuers obtain the requisite creditor consents under their debt pursuant to a collective action clause such as the collective action clause contained in the Bonds, if applicable, or otherwise. . . [We] cannot predict whether or in what manner the courts will resolve the dispute or how any such judgment will be applied or implemented.”
Historically, the restructuring of bonds involves negotiations between the external creditors and the sovereign. Deals struck during negotiations are not always able to placate all participants–resulting in holdout creditors. Additionally, some creditors sell their bonds at a discount in the secondary market to vulture funds, purchasers of distressed securities who seek full payment of the bonds. Holdout bondholders, including vulture funds, have the option to seek legal recourse and compel full payment. Conventionally, sovereigns may not formally subordinate payments due to holdout bondholders when issuing newly restructured bonds but may instead delay payments on the nonrestructured bonds while intending to or actually paying on restructured bonds. Under the Second Circuit’s broad interpretation of the pari passu clause, a sovereign’s informal subordination of bond payments to holdout bondholders may result in a contractual default under the pari passu clause.
The courts’ rulings have injected a new level of risk into the sovereign debt markets. The pro rata payment requirements ordered by the district court and recently affirmed by the Second Circuit make it more difficult for sovereigns to restructure external debt contracts with pari passu clauses that parallel the language of the pari passu clause in the FAA. Fundamentally, the courts’ rulings have provided external creditors with additional means of recourse against sovereigns, especially those able to satisfy payment obligations but who refuse to do so. Because of the absence of an international bankruptcy regime, holdout bondholders have limited recourse against a defaulting sovereign. The primary incentive for a sovereign to pay holdout bondholders is to maintain the sovereign’s access to international capital markets and, to a lesser degree, to avoid “harassment” from holdout bondholders. The courts’ broad interpretation of the pari passu clause, however, has provided holdout bondholders with additional leverage to argue for full payment on distressed securities.
The increased protection for creditors comes at a cost to those bondholders willing to restructure bond payments. The holdout bondholders will free ride on the bondholders who accept the haircut on the original bonds. The Argentinian restructure dealt with the freeriding problem through a law prohibiting higher payments to holdout bondholders. The courts’ rulings, however, hold that such a law violates the FAA’s pari passu clause.
If courts carry over the Second Circuit’s interpretation of the pari passu clause to corporate bonds, the consequences may be more pronounced. A broad interpretation of pari passu clause under corporate bonds may result in a perverse incentive for creditors. Such an interpretation incentivizes creditors to refuse to allow an insolvent business to make ordinary business payments in order to gain bargaining power against other creditors. This may result in a premature dissolution of the business. Consequently, creditors may not be able to support debtor’s business if just one creditor objects.
The possible blowback because of a broad interpretation to the pari passu clause has not convinced all sovereigns to drop the “payor” language in pari passu clauses in its bond contracts. Professor Mitu Gulati, a Duke Law professor, has compiled a list of sovereign bond offerings that show no significant changes from the boilerplate pari passu clause used in Argentina’s FAA. The list of countries includes Ivory Coast, Serbia, Mongolia, Costa Rica and Ukraine. Some have speculated that sovereigns may feel safe because the clause only becomes important if the economy implodes–a small, tail-end risk for some, because the sovereign does not want to be associated with novelty by changing the pari passu clause and because the collective action clauses in the sovereign’s bond contracts are sufficiently strong. Others argue that collective action clauses will not prevent the holdout issue seen in NML Capital v. Argentina. English law governs the bond contracts of Ukraine and Serbia. English courts have not adopted the views of the U.S. courts and it remains to be seen how this ruling will affect them.
It is unclear how the ruling in NML Capital v. Argentina will affect the sovereign debt market. Recent sovereign debt offerings have noted the risk and uncertainty surrounding the Second Circuit’s rulings, though many sovereign bond contracts preserve the boilerplate pari passu language used in Argentina’s bond contract. What is clear is that there is a real risk that Argentina will default on bonds issued under the FAA as a result of this decision.