Just about the first thing any law student learns about contracts is the rule “Pacta sunt servanda,” which means, “Agreements must be kept.”
The second thing they learn are all the exceptions to this rule, because the truth is that you can take a good thing too far. While honoring obligations to the full is certainly a good thing, it might not be the best in all circumstances. Law does not concern itself solely with what’s fair for the individual, but also with what’s best for society.
To this end, modern bankruptcy laws (also sometimes known as insolvency laws, but I am going to stick with bankruptcy here for the sake of simplicity) not only salvage as many assets for creditors as possible, they also seek to allow all parties involved a fresh start financially. This happens, for example, when the bankrupt person is discharged, usually after having made repayments for a certain number of years (but not necessarily amounting to the total amount owed) or when an insolvent company is wound up, in which case it ceases to exist and no further claims are possible.
Of course, a bankruptcy of any kind is hard on creditors. They typically receive only a fraction of monies owed, often well under 10%. However, it is important to remember that the creditor almost invariably sets all conditions for the loan, including whether to make it in the first place. Earned interest protects them against the losses from any one loan going bad and they are also free to secure their loans. So while it might initially seem unfair to discharge bankrupts who have not paid off their debts in full, it actually strikes a very good balance between the interests of both parties. Irresponsible lending and irresponsible borrowing are but two sides to the same coin.
But what happens when the borrower is not a person or a company, but a country?
This presents two problems that are very different from the normal bankruptcy scenario: one of them goes to the advantage of creditors and one of them goes to the advantage of debtors. To the advantage of debtors is the fact that countries are sovereign entities, which means that it is difficult to procure judgments or enforce laws against them. To the advantage of creditors is that in the long-run countries are pretty nearly always safe bets, because unlike companies they cannot just wind up operations and cease to exist. As long as you can afford to wait, you can always get something more from a country.
Considering the levels of crushing sovereign debt in the world today (with the USA, Ireland, Spain, Portugal and Greece further in debt than say Ethiopia, Egypt, Argentina, Angola or Chile), it is becoming ever more interesting to see how the interests of sovereign debtor and private creditor are going to balance out. The recent court case, NML Capital v Argentina might provide some insight into what the future holds for the rest of us.
Decades of political strife resulted in Argentina’s economy being mismanaged by everyone from a spendthrift military junta to modern free market gurus. The upshot was that by the turn of the millennium Argentina owed a lot of people a lot of money, but in particular it owed its bondholders over $100 billion. And they all got a big wake-up call when Argentina announced in 2001 that it would not be able to meet scheduled repayments on its debt. Some bondholders could not afford to wait for Argentina to repay later on, so they sold the bonds at rock-bottom prices to people who could. For a buyer this type of transaction is an extremely profitable business. They might buy a bond for 10 percent of its value, but eventually be paid 30 percent or 50 percent, or even 100 percent of the full value. Some companies engage in these activities on a regular basis and because they survive on preying on distressed entities, they are called “vulture funds.” When someone gets in trouble, they start to circle.
Throughout this crisis Argentina claimed that it was unable to pay back its bondholders in full if it was to prevent the Argentinian economy from collapsing. You may have heard the saying, “If I owe the bank a thousand dollars, I have a problem, if I owe the bank a million dollars, they have a problem.” Argentinian bondholders had a massive problem and over 90 percent of them eventually agreed to swap their bonds for new bonds at about one-third of the old bonds’ value. In other words, they took a 70 percent haircut on the bonds. It sounded better than letting Argentina melt down completely and ending up with even less or nothing at all.
Seven percent of creditors did not agree to the bond swap, although they were the only ones for whom that deal would actually have been very profitable.
Guess who they were?
Enter the battle on sovereign debt.
Argentina began make payments on the new devalued bonds, while the vulture funds continued to demand 100 percent repayment. In an effort to enforce that claim in late 2012, a fund known as NML Capital persuaded a Ghanaian court to issue an order impounding a visiting Argentinian warship (the Libertad). NML Capital intended to have the warship impounded until Argentina paid $20 million in exchange for its release.
This might have worked against a private company, but, like I said, countries are very hard to enforce against. And this is because countries are sovereign entities. Other nations are not permitted to sit in judgment on official state actions, much less seize assets that form an integral part of the state apparatus, such as a warship.
Argentina promptly dragged Ghana before the International Tribunal of the Law of the Sea, which unanimously told Ghana that it was violating Argentina’s sovereign immunity and to let the ship go ASAP. Ghana complied.
Round One to Argentina.
The vulture funds, however, also took action against Argentina before American courts. This was possible because Argentina agreed to New York jurisdiction when the bonds were initially sold. It also agreed that all creditors would be treated in accordance with the legal principle of pari passu, which means “with an equal step.” This is a standard clause and what it usually means is that all creditors’ claims are paid out of the debtors’ assets at the same percentage rate.
However, the New York court made an odd interpretation and ruled that the principle of pari passu means that Argentina must pay each bondholder the full amount of what that bondholder is entitled to, according to that bondholder’s agreement with Argentina. This would mean that Argentina needs to pay 93 percent of its bondholders 30 percent of what they were originally owed (because these are the terms that they agreed to), but pay the 7 percent of holdouts 100 percent of what they are owed (about $1.5 billion). The judgment seeks to get around the difficulties NML encountered when it impounded the Libertad by barring Argentina from using the US financial system to pay its other bondholders, many of whom are in the US. This means that Argentina will be unable to meet its obligations to the creditors who took a haircut without simultaneously paying off the holdouts. Because the US Supreme Court refused to hear Argentina’s appeal last week, the judgment is now operative.
The flaws for real-world application of this judgment are so significant that even the International Monetary Fund disapproves of it.
The judgment orders Argentina to pay back 100 percent of what it owes the vulture funds, but if an entity can make repayments in full, it is not bankrupt. The inability to make full repayments is what defines bankruptcy. So for 93% of bondholders Argentina effectively went bankrupt and both creditors and debtors paid a heavy price for their irresponsible borrowing and lending. But ultimately they acted in a socially responsible manner. Bondholders recognized that it would be better to help Argentina get back on its feet by taking a hit. This would enable Argentina to repay them at least a substantial fraction of monies owed within a relatively foreseeable time period. For its part, Argentina accepted that it had an obligation to make those repayments and has honored this agreement.
But the vulture funds seem to inhabit an alternate reality where Argentina never defaulted, despite the fact that they bought Argentinian bonds after this very event had actually occurred. This judgment privileges the vulture funds by granting them a type of treatment (full repayment) that would be impossible to bestow on all creditors. By adopting this very strange definition of equal treatment, the court has essentially transformed itself into little more than an enforcement agent for a hedge fund with delusions of grandeur, an actor which doesn’t just demand a good deal, but demands everything. NML would still have made a massive profit if it had agreed to the 30 percent payback rate. As it stands, Argentina’s ambassador to the US estimates that repaying the vulture funds in full would net them a 1,300 percent return on investment.
Argentina’s real creditors already got burned, but it must pale into insignificance next to the pain of having to watch NML collect in full, an action only enabled by their own previous compromises. Surely this will impact creditors’ willingness to restructure in the future as they wait for someone else to volunteer to take the fall, so that they can be the ones to clean up. It might become hard to obtain even the kind of creditor consensus that can also bind holdouts to an agreement in some jurisdictions. Considering that many Western countries are further in debt than Argentina was at the time it defaulted, this could have consequences for us all.
The statements, views and opinions expressed in this column are solely those of the author and do not necessarily represent those of RT.