The consequences of Elliott vs Argentina

By Felix Salmon
November 26, 2012

The FT — which has been excellent covering the case of Elliott vs Argentina — has now weighed in from its editorial page:

The original bonds could have prevented this outcome. But they did not include collective action clauses, which allow a large majority of creditors to bind holdouts to a restructuring…

Many countries have issued debt under foreign law without CACs. Should their debt be unpayable, only an orderly restructuring will enable them to move on. If Mr Griesa’s ruling sets a precedent, a single holdout creditor will be able to exclude a sovereign debtor from international markets indefinitely…

So sovereign creditors should learn the importance of CACs, which should be standard in all new bonds – as the eurozone has done.

This has elicited a short but heartfelt cry from from Anna Gelpern, which is worth translating into English, because the FT has gone and made exactly the same mistake that the Second Circuit made. Let’s be clear about this: if the current mess between Elliott and Argentina is a problem, then CACs are not the solution. Collective Action Clauses may or may not be a good idea, at the margin (they probably are). But unless you’re a country like Belize, which only has one bond outstanding, they don’t really solve the problem of holdouts.

That’s because CACs live within bonds, rather than across them. Any decently-respectable sovereign will have put a good amount of effort into building up a yield curve — something very valuable for any domestic companies looking to borrow on the international markets. A yield curve is a line joining up a long series of dots, and each dot in that line represents a bond issue. A couple of those bond issues will be big, liquid benchmark issues; others will be much smaller, and some will be relatively tiny, the opportunistic result of what’s known as “reverse inquiry” bids from investors wanting to lend the country money on certain terms.

Even if all of those dots have CACs, many of them will be small, on the order of say $100 million or so face value; these are known in the market as “orphans”, and they tend to trade at a discount because they’re illiquid. So when a sovereign credit is trading at distressed levels, orphan bonds will be even cheaper. If the sovereign’s benchmark bonds are trading at 25 cents on the dollar, the orphans might trade at 20 cents. As a result, a vulture fund could buy up 25% of a $100 million bond issue for just $5 million.

At that point, the CAC will do the issuer no good at all. If the CAC needs 75% of bondholders to accept a deal, then a carefully-picked $5 million purchase can effectively veto the deal, and turn the entire bond issue into a holdout.

With old bond exchanges, a country would put an offer on the table, and would go ahead with the offer if a certain percentage of bondholders agreed to it. At that point, everybody who didn’t agree to the offer would become a holdout. The FT and the Second Circuit seem to think there’s a better way of doing things: that instead of swapping out old bonds for new bonds, sovereigns should just ask bondholders to vote to accept a change in payments on their existing bonds. If the percentage voting in favor is higher than the CAC threshhold, then, presto, no exchange is needed: the old bonds just change their payment terms, and magically transmogrify into new bonds.

The problem is that there’s no way a country can realistically do that for all of its outstanding bonds simultaneously. While it will reach the CAC threshhold for most of its bonds, there will always be a few holdouts — and at that point, we’re back to exactly the same situation we’re seeing in Elliott vs Argentina.

All of which is to say that whenever there’s a sovereign restructuring, there will be holdouts. They’re something of a fact of life — but so long as countries like Argentina can credibly threaten not to pay them, restructurings can still happen, either with or without CACs.

The problem with the Elliott vs Argentina precedent, if it ends up with Elliott getting paid, is that it eviscerates the credibility of that threat. If holdouts have a powerful tool which ensures that they will get paid after a restructuring, then restructurings will never get off the ground: no bondholder will have any incentive to accept a haircut if they can instead holdout and get paid in full.

The FT is right, then, that the courts need to urgently deal with the can of worms that has been opened by Judge Griesa. The consequences of his decision, if it’s allowed to stand, are unknowable, but they will certainly be huge. What would happen to Argentina’s judgment creditors, for instance, who held bonds but then reduced them to a judgment against Argentina? No one knows. What about creditors bearing other judgments against the country, like those who have won cases at ICSID? What would happen to the preferred creditor status of the IMF and the World Bank? Could vultures start attacking payments to those institutions, too? And never mind emerging-market sovereigns: what would happen to standard US contracts, where a company might choose to pay one creditor while stiff-arming another? Would all such choices end up with creditors fighting each other in the courts, so long as they had a precious pari passu clause?

I’m not convinced that the Supreme Court is the right place for these decisions to be made: the issues are basically those surrounding the smooth functioning of markets, rather than being Constitutional in nature. And as such, the Second Circuit, probably sitting en banc, is best placed to ensure that New York remains a place where contract law works in predicable, rather than highly unpredictable, ways.

But what’s certain is that the legal issues here are enormous — much bigger than Argentina — and need to be dealt with deliberately, rather than in a rushed manner. As a result, it’s very important that the Second Circuit reinstate the stay which Judge Griesa so aggressively withheld when he handed down his most recent opinion.

Interestingly, former Argentine central bank governor Mario Blejer has also weighed in, saying that “the preservation of the integrity of judicial rulings is paramount” and that as a result it’s more important than ever that Griesa be overturned. Investors should not for one minute, however, believe that the implication of Blejer’s op-ed is that Argentina will follow Griesa’s ruling if it’s not overturned. Griesa has done the impossible, here: he’s managed to unite the Argentine government and opposition, against a common enemy. (Himself.)

No one in Argentina thinks that Elliott should be paid. And although no one thinks that Argentina should default, either, there might need to be a period of technical default just in order to ensure Elliott doesn’t get its $1.3 billion. Alternatively, Argentina could just make the scheduled coupon payment to Bank of New York, and let creditors work out for themselves how to get their hands on their money. They would certainly sue Bank of New York for the money that BoNY was holding in trust for them, and it’s not at all clear, if Argentina actually made the payment, that the CDS would get triggered.

So the way I see it, there are basically four possibilities here. The first is that Argentina gets its stay back, and ultimately the courts overturn Griesa. In that case, we’re back to the status quo ante. But what happens if Griesa’s ruling is upheld? It’s possible, but highly unlikely, that Argentina will just give up and pay Elliott the $1.3 billion. It’s also possible that it will default on everybody, and begin the process of paying exchange bondholders in some new manner in Buenos Aires.

Finally, Argentina can make the payment to BoNY, and let its various creditors and agents fight it out among themselves. If it chose that option, it would be fascinating to see what happened to the price of Argentine bonds. How much is a bond worth, when all coupon and principal payments belong to you, the bondholder, but are being held irretrievably at BoNY? It’s an interesting existential question.

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