Why we might soon see another Argentine default

By Felix Salmon
November 22, 2012

Judge Thomas Griesa, of the Southern District court in Manhattan, is mad as hell, and he’s not going to take it any more. Yesterday he unleashed three different orders and declarations on Argentina, all of which might as well have been dictated to him by Elliott Associates, the plaintiff suing Argentina for some $1.3 billion.

You’ll remember that last month, the Second Circuit, upholding one of Griesa’s orders, asked Griesa to clarify a couple of matters before the order could be fully enforced. In April, after Griesa’s orders first came out, I said that they were “notable for their lack of legal reasoning”, and added that “Griesa is throwing his hands in the air, here, and basically punting the whole issue up to the appeals court.”

Well, the appeals court agreed: while upholding Griesa’s orders, it also asked him for something much more detailed. Which is exactly what he has now delivered.

Three different orders from Griesa arrived yesterday, all related. The meatiest is this one; the other two are here and here. In them, Griesa answers the questions put to him by the Second Circuit: firstly, what exactly does Argentina need to do, in order to comply with his order? And secondly, how broad are the orders, in terms of including intermediary banks and the clearing system more generally? Specifically, does Bank of New York risk being punished for the actions of a Latin American sovereign state over which it has no control?

Griesa answered those questions as aggressively as he possibly could. The answer to the first: if Argentina’s going to make any coupon payment, in full, to the holders of its exchange bonds, then Argentina must also, at the same time, pay out Elliott Associates in full: all the principal and interest owed, which comes to some $1.3 billion. And the answer to the second: yes, Bank of New York is absolutely covered by the order, that’s the whole point. Argentina simply ignores orders from New York which it finds inconvenient; Bank of New York can’t. As Griesa puts it:

It goes without saying that if Argentina is able to make the payments on the Exchange Bonds without making the payments to plaintiffs, the District Court and Court of Appeals’ rulings and the Injunctions will be entirely for naught. To avoid this, it is necessary that the process for making payments on the Exchange Bonds be covered by the Injunctions, and that the parties participating in that process be so covered.

Griesa, here, is essentially ignoring Bank of New York’s heartfelt “please leave us out of this” plea. BoNY makes some very strong points in its brief, but they come down to a very simple concept: Griesa is basically asking BoNY to do the impossible. BoNY acts on behalf of Argentina’s exchange bondholders, and as such, if Argentina sends BoNY a coupon payment, then BoNY, in turn, has a legal obligation to remit that money to those bondholders. At the same time, however, Griesa’s new order gives BoNY a legal obligation not to remit the money to the exchange bondholders, unless and until Argentina has paid off Elliott Associates at the same time.

BoNY, then, asked Griesa a simple question: “Are you asking us to break the law?”:

BNY Mellon should not be forced by Argentina’s independent violation of the Injunction to choose between exposing itself to the risk of contempt, on the one hand, or the risk of claims from Exchange Holders for breach of the Indenture, on the other.

The implication of the BoNY brief is that if Griesa’s order is upheld, then it won’t pay the exchange bondholders, since there’s a clause in the indenture saying that in no event will BoNY be expected “to do anything which may be illegal or contrary to applicable law or regulation”. But, BoNY very much wanted Griesa to give an explicit order to that effect, saying that BoNY should not consider itself bound by its agreement with the exchange bondholders to actually pay those bondholders.

But Griesa disappointed BoNY: he says simply that if Argentina doesn’t pay off Elliott Associates as ordered, then BoNY would “properly be held responsible for making sure that their actions are not steps to carry out a law violation, and they should avoid taking such steps.”

Now the Second Circuit, in asking Griesa to clarify these matters, was clearly worried about orders which bind third parties too tightly. BoNY cites Learned Hand (and many others) in its brief:

No court can make a decree which will bind anyone but a party… If it assumes to do so, the decree is pro tanto brutum fulmen, and the persons enjoined are free to ignore it… The only occasion when a person not a party may be punished, is when he has helped to bring about, not merely what the decree has forbidden, because it may have gone too far, but what it has power to forbid.

Clearly, BoNY has no “power to forbid” Argentina from doing whatever Argentina wants, in terms of paying or not paying Elliott Associates. BoNY doesn’t even represent Argentina: it works for the bondholders. And so BoNY raises the prospect of this case going all the way to the Supreme Court:

To threaten BNY Mellon with contempt in this instance would unhinge this extraordinary power from its Constitutional moorings.

Personally, I don’t think that the Supreme Court will show much interest. This is a civil case, different circuits haven’t come to differing decisions on the matter, and, when it comes to matters of finance, the Second Circuit has all the expertise. Still, it’s worth noting that one of the largest holders of exchange bonds, Gramercy Advisors, has hired David Boies to represent it and to fight Griesa’s rulings. Boies is up against his old adversary (and occasional ally) Ted Olson, here: Olson is representing Elliott.

But it might be too late for Boies to get stuck in, at this point. When Griesa made his original ruling, he also put a stay on it, pending appeal to the Second Circuit. And these new rulings, too, are being automatically kicked back up to the Second Circuit for reconsideration. But there’s a big difference: this time, there’s no stay. Earlier this year, the Second Circuit could (and did) take lots of time to consider the matter at hand, and all the various briefs from interested parties like Gramercy. (Which, ironically, made its name on the other side, as a quasi-vulture investor suing Ecuador, but that’s another story.)

This time around, the Second Circuit doesn’t have the luxury of time. Griesa has lifted the stay and says that Argentina has to comply with his order when its next big $3 billion payment is due on December 15. The case will surely still be in some kind of appeals limbo at that point, and Griesa says that therefore it’s OK for Argentina to take the $1.3 billion it owes Elliott and pay it into escrow. But Argentina surely knows that once the $1.3 billion has gone into an American escrow account, it will never see that money again — while some combination of holdout creditors will ultimately get their hands on it. Paying the money into escrow is tantamount to paying the holdouts, and that’s something Argentine president Cristina Kirchner has vowed never to do.

All of which means that there is now a very, very real risk that thanks to Griesa’s rulings, Argentina is going to end up defaulting to its exchange bondholders. If Argentina transfers the December 15 payments to Bank of New York and doesn’t at the same time pay $1.3 billion into escrow, it’s not at all clear what BoNY is supposed to do. The money will rightfully belong to the exchange bondholders, but BoNY will be enjoined from actually paying them. And if the bondholders don’t get their money, that’s a default.

This affects the CDS market, of course: there’s disagreement on whether a missed payment on December 15 would trigger Argentine CDS, since that payment is actually a payment on GDP warrants rather than on debt. But there’s a proper coupon payment due on December 31, and if that money didn’t arrive, then the CDS would almost certainly be triggered. As a result, the spreads on Argentine CDS are somewhere over 2,000bp, and we’ve now reached the point at which Argentine-law domestic debt is now considered safer than Argentina’s New York law foreign debt. Here’s the chart, from JP Morgan:

It all adds up to an unholy mess, really. After all, this case is much bigger than just Elliott Associates vs Argentina. If Elliott gets its money, or even comes close, then lots of other holdout creditors will pull the same legal move, with the same legal results; it’s possible that some of them will even try to get their hands on the money going to Elliott, since they’re equally entitled to it. Then there’s the whole question of whether holdouts who reduced their claims to court judgments can also follow the Elliott path. No one knows the answer to that one.

There are holdout creditors holding bonds from other countries, too; they’ll probably follow Elliott’s lead as well. Every pari passu clause is a little bit different, but Griesa at least is very clear in his reasoning: he’s not trying to narrowly enforce the meaning of the pari passu clause, so much as he’s broadly trying to ensure that justice is served and Argentina’s long-suffering holdout creditors get paid.

And then there’s the biggest question of all: how on earth are countries ever meant to be able to restructure their debts, if orders like this allow holdout creditors to get paid in full? The Second Circuit seems to think that collective action clauses can do the trick, but nobody else thinks that way; Anna Gelpern explains why.

All eyes are now on the Second Circuit. Argentina’s best hope is that the Second Circuit will be swayed by the arguments from BoNY, the New York Fed, the Depository Trust Company, the Clearing House Association, and just about everybody else with a stake in the smooth functioning of New York markets. They upheld Griesa’s initial order, but maybe they’ll tack back the other way this time around, and overturn him.

It’s possible, but frankly I don’t know anybody who thinks it’s particularly likely. And Griesa, by refusing to extend the stay on his order, has deliberately made a protracted Second Circuit deliberation very difficult. If the Second Circuit wants to protect the New York markets by freeing BoNY and others from Griesa’s order, it’ll have to do so before December 15. Which is possible, but given how slowly the judges moved last time, doesn’t seem particularly likely.

If I had to make a prediction in this case, I’d say that the Second Circuit is not going to come to the exchange bondholders’ protection (and, for that matter, neither will the Supreme Court) — and that Argentina is not going to pay the $1.3 billion into escrow. It might make the $3 billion payment that is due to BoNY, but if it does, BoNY will heed Griesa’s order and will not send that payment on to bondholders. Alternatively, Argentina might try to make the payment some other way, via some new paying agent in Argentina, but that would be very messy indeed, and a lot of bondholders would still end up unpaid.

All of which means that in a weird way, the obvious thing for Argentina to do is to simply default on all its foreign obligations. It could then launch another exchange offer, saying that anybody holding the exchange bonds could swap them into domestic Argentine bonds with exactly the same terms; at that point, Argentina would happily make up any arrears.

Such a move would certainly trigger Argentina’s credit default swaps; in doing so, it would deliver a tidy sum to Elliott Associates, which is rumored to hold a large quantity of Argentine CDS. But at least Elliott wouldn’t get paid directly by Argentina, and Cristina could stay true to her promises.

Argentina might have been paying holders of its New York law bonds for years now, but it has never had access to New York markets; in that sense, by abandoning the foreign markets, it would only be abandoning markets which have served it no real purpose. Hundreds of foreign creditors already own domestic Argentine debt, denominated both in pesos and dollars; that system has been proven to work reasonably well. So it makes a certain amount of sense for Argentina to behave as aggressively towards Griesa as Griesa has behaved towards Argentina. If you want to get paid, it can tell its bondholders, you’re going to have to get paid in Argentina, since the New York courts won’t let us pay you in New York. The bondholders won’t like it one bit, but they’d ultimately go along. Really, they wouldn’t have much choice.

Update: JPMorgan’s Vladimir Werning has a great note with the title “Argentina: Set to appeal until it becomes necessary to offer investors (the now NPV positive!) off-shore payment option”. Basically, Argentina will appeal to the Second Circuit (the case is already there) and hope that the Second Circuit reinstates the stay. If that happens, and if it loses, then it will appeal to the full en banc Second Circuit, and even ultimately to the Supreme Court. But first it needs that stay — and if it doesn’t get the stay, then that’s going to force its hand. The clock is ticking: unless the Second Circuit overrules Griesa by reinstating the stay, then Argentina will start telling its bondholders that if they want to get paid, they’re going to have to get paid in Argentina.

 

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