Opinion

Felix Salmon

Annals of ignoble cowardice, Second Circuit edition

By Felix Salmon
September 10, 2013

I spent all of yesterday at a fascinating and wonky conference in London, on the economics and law of sovereign debt. I gave a short talk on the latest developments in Elliott vs Argentina (a/k/a NML vs Argentina), and specifically on the decision which was handed down by the Second Circuit court of appeals on August 23. These are the notes I drew up for the talk.

And now abide faith, hope, love, these three; but the greatest of these is love.

We’ve all heard these words at weddings, and even sometimes at funerals. But I’ve written my own version, just for pari passu geeks. It goes something like this:

And now abide secured, unsecured, judgments, these three; but the greatest of these is a judgment.

I am not a lawyer. But maybe because I’m not a lawyer, I feel like I can look at what’s going on in the NML vs Argentina case from a little bit of a distance. And when I do that, what I see is a series of court decisions which have undermined the very way in which debt is understood to work.

Remember that pari passu, at heart, is all about ranking; it’s about seniority of payment. And the way I see it, seniority works in a pretty well-established way. First of all, there’s unsecured debt. Mitu lends me money, and now I owe him a certain sum on a certain date. It’s pretty simple. If I pay him, he’s happy; if I don’t pay him, he’s sad.

Next up, there’s secured debt. Henrik lends me money, but he’s worried that I might not be able to pay him back. So he insists on a lien: he wants me to put up my country house as collateral. As with Mitu, I still owe Henrik a certain sum on a certain date. And as with Mitu, if I pay him, he’s happy. But if I don’t pay him, he goes straight to plan B: he seizes my country house, sells it, and uses the proceeds to ensure that he’s repaid in full. Still, Henrik can still end up unhappy. If I don’t pay him, and if my country house has burned down, then there’s nothing to seize, and he ends up where Mitu was, holding a defaulted obligation.

This is where the courts come in. Once I’m in default, any of my creditors — Mitu, Henrik, Joseph, it doesn’t matter — can go along to a court and reduce their obligation to a judgment. And judgments are very powerful things. Because once you’re armed with a judgment, you basically become an ultra-secured creditor. If I own a country house, you can forcibly attach that, and sell it, and pay yourself from the proceeds. But if my country house has burned down, you can attach any of my other possessions instead — you can attach my stock portfolio, or my wine cellar, or even, most simply, my bank account. Anything I own, if it can be reached by the long arm of the law, is now within your grasp.

There are only two ways for me to foil you, if I have assets and you have a judgment. The first is for me to declare bankruptcy. But for the sake of argument, let’s say that bankruptcy isn’t an option. Maybe my assets vastly exceed my liabilities. The second is for me to somehow move my assets to where they can’t be touched by your courts. Maybe I smuggle my stamp collection into a safety deposit box in Iran. It’s not going to do you much good there, because your judicial system isn’t going to be able to extract it from that box and sell it.

Still, even if you have a judgment, you can’t attach what isn’t mine. For instance, let’s say that Joseph has a bank account. If I owe Mitu money, even if he’s armed with a judgment, he can’t barge in and attach Joseph’s bank account. Just mine.

Now it’s true that I borrowed money from Mitu and from Henrik, and that I defaulted on both of those loans. I borrowed money from Joseph, as well. Joseph has something weird — he has something called subordinated debt. In his loan documentation, it explicitly says: “I will not pay you any money unless and until I’ve paid Mitu first. Mitu is senior, and you, Joseph, are junior.”

So when I default on my obligation to Mitu, Joseph is also sad: he knows that he’s junior to Mitu, which means that I’m not going to be paying my subordinated creditors any time soon.

But when Joseph’s coupon date rolls around, guess what? I walk into his bank, take out a wad of cash, and tell the bank to deposit into Joseph’s account every penny that he’s owed. Now, Joseph is happy: he’s just received an unexpected windfall. And Mitu is furious, because he knows what I promised Joseph.

Mitu has been patient with me, so far, but now his patience has run out, and finally he decides to go to court. “I have a piece of paper here which clearly says that I’m a senior creditor,” he tells the judge. “And Felix is going and paying his junior creditors, without paying me!”

The judge is sympathetic, and wants to help out Mitu in any way he can. “I’ll tell you what,” he says. “I’ll give you a judgment, that’s what judges do. And then, armed with that judgment, you can attach anything that Felix owns, and use those assets to pay yourself everything you’re owed.” This mollifies Mitu, because he knows that judgments are the best thing you can have. But it takes time to locate and attach assets, and when Joseph’s next coupon date rolls around, I go and do exactly the same thing: I walk into Joseph’s bank, and tell them  to deposit a bunch of money into Joseph’s account.

Now Mitu is really hopping mad, and he goes back to the judge, who is still sympathetic. But then Mitu goes too far. He asks the judge to bring down a judgment not on me, but rather on Joseph. “Tell Joseph that he owes me the money,” says Mitu. The judge is a bit puzzled. “Does Joseph owe you money?” he asks. “Where do you have a contract with Joseph?”

“Oh,” says Mitu. “Good point. I don’t have a contract with Joseph, I only have a contract with Felix. So you can’t tell Joseph that he owes me money. But hang on, I have another idea. I can see what Felix is doing now: he’s paying Joseph, without paying me. So I want you to go to Joseph’s bank, and tell them that the next time Felix deposits money into Joseph’s account, they should refuse to do that.”

Now the judge is really puzzled. “Joseph’s bank?” he says. What have they got to do with anything? They’re just the institution which looks after Joseph’s money. And in fact, they have a very clear contract of their own, with Joseph, and they don’t have any kind of contract with you. Felix promised to pay you money, and he broke that promise, and I’ve given you a powerful judgment saying that Felix owes you money. But neither Joseph nor Joseph’s bank owes you money, so I’m not going to start slapping injunctions on them.”

Mitu is unimpressed. “But Felix promised that he wouldn’t pay Joseph without having paid me first!” The judge, on the other hand, is equally unimpressed. “Yes, Felix broke his promise. Felix broke his promise the minute that he defaulted on his payment obligation to you. He has since broken another promise. And he can go head and break a thousand more. When Felix breaks his promise, I enter a judgment against Felix. I’ve done that. But I’m not going to start handing down judgments on Joseph, or on Joseph’s bank, just because Felix has broken a promise. Those guys are independent actors, and have no control over what Felix does. So leave them alone.”

Most of the time, this story works out quite well for Mitu. Because my assets exceed my liabilities, and because Mitu has a judgment against me, it’s not hard for him to get satisfaction. But regardless of whether Mitu ends up being satisfied or not, the principle is clear. The remedy, if I break my contractual promise, is that my creditor can get a judgment against me. And a judgment is to all intents and purposes the most senior claim that anybody can have.

This is why I find the behavior of the judges in New York to be so bizarre. Firstly, they have turned the natural order of creditors on its head. Secured, unsecured, judgments, these three; now the greatest of these is, bizarrely, unsecured, with a pari passu clause. It’s the unsecured creditors who are being able to get remedies which — at least so far — have proven unavailable to either secured creditors or judgment creditors.

Secondly, there’s no real logic to how this new system of jurisprudence should be enforced. It seems to me that if Joseph has explicitly subordinated debt, and Mitu goes to court, then Mitu is going to come away empty-handed, because the explicit subordination is in Joseph’s bond documentation rather than in Mitu’s. But if Mitu manages to find the right flavor of pari passu clause in his own documentation, then suddenly everything changes, and the nuclear remedy becomes magically available.

Thirdly, the judges have created a new class of activity, for debtors, which is Worse Than Default. It used to be that when it came to debt contracts, defaulting was the worst thing you could do. That’s no longer the case: now, the worst thing you can do is to selectively default. In other words, if I pay Joseph and don’t pay Mitu, that’s considered worse than if I don’t pay Joseph and don’t pay Mitu. Because only in the first case — only when I’m in partial default — will New York’s judges roll out their brand-new thermonuclear remedy.

Fourthly, it is now entirely acceptable, under New York’s system of jurisprudence, for judges to punish the innocent, rather than the guilty. Neither Bank of New York nor the exchange bondholders have done anything wrong. All they’re doing is collecting the money they are rightfully owed. But if these rulings stand, they won’t be allowed to do that any more.

This is the bit which annoys me most about the Second Circuit’s ruling. The courts are clearly punishing the innocent, with these rulings, and yet are bending over backwards to pretend that they’re not. If you’re going to do something as unintuitive as this — if you’re going to make unsecured non-judgment creditors effectively the most senior, and create a brand-new nuclear remedy, and punish the innocent, and violate a whole bunch of sovereign-immunity precedent while doing so — then at the very least you should be open and honest about what you’re doing and why you’re doing it.

Instead, the rulings of both Judge Griesa and the Second Circuit are run through with pinched and disingenuous legal reasoning. They refuse to step back and take responsibility for the big-picture consequences of their actions, and it’s that, to me, which is by far the worst thing they’ve done. I have precious little sympathy for Argentina, in this case, and not much for Elliott Associates either — but at least both of them are openly and honestly making the best case they possibly can for their actions. The New York courts, by contrast, are just being poltroons, and it’s their ignoble cowardice which really drives me up the wall and which is the main reason the Supreme Court should accpet this case and decide it head on.

I can understand the pique and frustration which led Judge Griesa to enter his original judgment against Argentina. When an actor in your court is being as consistently and unapologetically contumacious as Argentina, eventually you reach breaking point. But when that kind of thing happens, it’s the job of the appeals court to provide cooler heads, and to say hang on a minute, what are we doing here, are we sure we really want to go down this road. Especially when you’re the court which has for decades looked after the New York payments system and the US financial architecture.

But that’s not what the Second Circuit did. Instead, they ducked all the big questions, and decided this case as narrowly and pedantically as they conceivably could. Which is why they — much more than Elliott Associates, or Argentina, or anybody else — are the biggest villains of this story. Of all the actors on stage, it’s the Second Circuit which has acted in the worst faith. I hope — against hope — that the Supreme Court will hold them to account for their actions.

Comments
14 comments so far | RSS Comments RSS

The New York courts, by contrast, are just being poltroons, and it’s their ignoble cowardice which really drives me up the wall and which is the main reason the Supreme Court should accpet this case and decide it head on.

… it’s their ignoble cowardice … it’s their ignoble cowardice … it’s their ignoble cowardice

Of all the actors on stage, it’s the Second Circuit which has acted in the worst faith. I hope — against hope — that the Supreme Court will hold them to account for their actions.

… worst faith … worst faith … worst faith …

… not at all agree with such statements demented
and the whole article is the work of a crazy!!!

Posted by giacomini | Report as abusive
 

How is what you are doing in your example (stiffing Mitu and given the money to Joseph) any different than fraudulent conveyance?

nd as I understand it, from time immemorial courts have had the power to order the clawback of fraudulent conveyances, even if the recipient of the conveyance was innocent.

Posted by Lagrangian | Report as abusive
 

“which is the main reason the Supreme Court should accpet this case”

Might want to correct, then please delete this comment.

Posted by REDruin | Report as abusive
 

Junior debt can be looked on as creating an implied third party beneficiary contract with existing senior debt.

If A owes B money and B owes C money B can tell A to pay C and create a situation where C is in privity with A.

In the Elliot situation A is owed by B, but knows B owes C money and agrees not to be paid until after C. This could be interpreted as a form of a 3rd party beneficiary contract. At least, that’s what I’d argue.

Posted by Zdneal | Report as abusive
 

“Neither Bank of New York nor the exchange bondholders have done anything wrong.”

Right on—it’s not like willful complicity in a scheme to defraud senior creditors by transferring property to third parties could be prosecuted as criminal conspiracy or anything.

Posted by DCLiam | Report as abusive
 

The other creditors (i.e. Joseph) are only innocent because they are passive. They are receiving money in violation of their contracts and of judicial decisions, and for them to assume they will get to keep that is naive. For better or worse, lots of passive people get swept up when the government says illegal asset transfers are happening.

And your reasoning as to why the order of seniority has been inverted is opaque. Have other creditors with different bond contracts tried the same tactics without success in the 2nd circuit? My sense is that Elliott is the first to try it with bonds that are enforceable in US courts.

Posted by AngryInCali | Report as abusive
 

The U.S. Supreme Court quickly refuses the argentine appeal, and decides for immediate negotiations in order to clear conditions exist, when the “Rights Upon Future Offers (RUFO)” ends (12/31/14).

It could be acceptable for all Holdouts, as also offered by NLM: full capital repayment with a reduction of interest.

In detail: The terms are described in the respective bond conditions.It means, that defaulted bonds, which have become due before 12/31/2014, should be repayed at 100% on 01/01/2015 (end of “RUFO ”). What could be negotiated, is the amount of the outstanding interest. Bonds, which term ends later than 12/31/2014, run normal further (with abbreviated interest that should also have to be negotiated)

Posted by GermanHoldout | Report as abusive
 

This could (will) be the solution(?):

The U.S. Supreme Court quickly refuses the argentine appeal, and decides for immediate negotiations in order to clear conditions exist, when the “Rights Upon Future Offers (RUFO)” ends (12/31/14).

It could be acceptable for all Holdouts, as also offered by NLM: full capital repayment with a reduction of interest.

In detail: The terms are described in the respective bond conditions.It means, that defaulted bonds, which have become due before 12/31/2014, should be repayed at 100% on 01/01/2015 (end of “RUFO ”). What could be negotiated, is the amount of the outstanding interest. Bonds, which term ends later than 12/31/2014, run normal further (with abbreviated interest that should also have to be negotiated)

Posted by GermanHoldout | Report as abusive
 

Thanks for the coverage on this issue Felix. You’re one of a small handful of main streamers paying any attention to this issue so the people who care about it really appreciate you time!

I think you’ve seen enough debt restructurings to know that NOTHING is ever as cut and dry as it should be by statute or contract. I think many people would like to hear more on the big picture sovereignty issue. Do you believe that there are different levels of sovereignty? I would argue that when a country A issues debt in country B that it is not truly Sovereign debt.

Argentina’s position that they can pay junior creditors a pittance while zeroing out the senior creditor holdouts is childishly laughably stupidly arrogant. If creditors begin to get the drift that debtors can get away with that kind of crap then you know the cost of credit moves much higher… and that hurts only the good people and places of the world who pay their bills… deadbeats after all care not what the interest rate is because they ain’t payin it anyway.

I’m 100% with you on one thing though… the world needs a whole lot more equity!

Posted by y2kurtus | Report as abusive
 

Felix, I’d like to hear an attorney who works with credit issues weigh in on your perspective. I don’t fit that bill, but I think that many of your points are simply wrong in an individual or corporate context. The complicating factor here is that Argentina is a sovereign, and therefore benefits from certain immunities and can’t be declared bankrupt.

Firstly, look up bankruptcy preference period. At least in a corporate context, the debtor’s payment to Joseph would be voided under U.S. bankruptcy law if it occurred within 90 days prior to the filing of bankruptcy – that’s whether or not any judgment is in place, merely if it advantages Joseph relative to other senior or similarly situated creditors. (That’s subject to certain exemptions such as payments made in the ordinary course of business, which your example doesn’t fit). That period would be a year if Joseph is an insider – e.g, if Joseph is the CEO or a relative of the CEO. So, Joseph would be obligated to pay that money to the debtors’ bankruptcy estate for the benefit of all creditors. It’s a not uncommon occurrence.

Second, referring again to a corporate context, it’s common that subordination agreements are tri-party agreements among the debtor, senior creditor(s), and subordinated creditor(s). A provision of them is that a subordinated creditor receiving payment in violation of the terms of subordination agrees to turn said payment over to the senior creditor(s). Basically, it explicitly spells out Zdneal’s implied contract. This one may be more of a quibble, as I don’t think that all senior / subordinated creditor relationships are structured this way.

Third, a thought experiment. Let’s say, for simplicity, that your net worth is $10 million with no debt. I obtain a $10 million judgement against you for whatever reason – let’s say it’s a personal injury claim for the sake of argument. Your perspective is that you absolutely refuse to me, so you instead – after the judgement – transfer all of your assets to a charity. (A true transfer to a bona fide 3rd-party charity, not trying to shield them with a trust that also supplies you with income or anything of that sort.) Are you really saying that you think that I won’t be able to get those assets, or at least part of them, from the charity? That’s a textbook fraudulent transfer, and I’m pretty damn sure that I’d be able to go after the charity to get the assets that you transferred to them.

Posted by realist50 | Report as abusive
 

* “refuse to pay me” midway through last paragraph

Posted by realist50 | Report as abusive
 

elliot paid 40 millions to buy a defaulted debt in 2008 and now he wants 1400 millions… that is not fair.
Elliot gave money to differents politicians in usa, now they are using that influence they paid.

Posted by nicko123 | Report as abusive
 

Back in the days where I was a banking trainee, I was taught that the foundation of banking was judicial enforcement. I was also taught to be very careful at not benefiting or helping fraudulent conveyance. Based on what you exposed, this is what Joseph is doing.

Posted by cmonneron | Report as abusive
 

A owes B and C money equally. A decides not to pay B or C unless they take a haircut. C agrees to take a haircut, but B does not. Furthermore, C knows that B will not take a haircut.

If A tries to pay C, but not B: C cannot claim to be an innocent.

Posted by Boyardee | Report as abusive
 

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