A missed debt repayment this week means Argentina further extends its exclusion from the world’s capital markets. The country must find the money to repay all its creditors, or agree to a restructuring deal within 30 days, otherwise it will go into a technical default.
Argentina last defaulted on its debt repayments in 2001, following a prolonged economic recession and a period of rapid inflation. Twelve years on, the situation has come to a head once again after the US Supreme Court ruled in favour of one of its remaining holdout creditors, NML Capital.
NML is a “vulture” fund. Its business model requires it to buy defaulted debt cheap on the secondary market then sue debtors in distress for full repayment in US courts.
But the impact of the court’s decision will be felt far beyond Argentina. The fact US judges have taken such a proactive stand in the sovereign debt markets represents a radical change – and not for the better.
Swap shop
When a national government wishes to raise funds on international capital markets it issues sovereign bond contracts in foreign law. Private creditors buy these bonds, effectively transferring money to the debtor country. As these bonds are contracts, default or the failure to repay debt is therefore legally a breach of contract.
On breach it is not unusual for a court to order a defaulting debtor to repay its creditors in full, however international law protects sovereign assets from seizure. It is therefore almost impossible for creditors to collect from defaulting sovereigns – whether you invested in Russian sovereign bonds in the late 1990s, or Argentine ones in 2001, you were taking a clear risk. Usually most creditors negotiate debt swaps – voluntary exchanges of defaulted bonds for new bonds with lower face value payments.
Debt swaps are mutually beneficial. The country buys time to recover from the deep recession that often pre-empted the default. The repayments also signal a willingness to repay allowing the sovereign to regain access to primary capital markets. Bond holders are assured of a steady stream of payments and avoid uncertain and prolonged litigation. Something is generally considered to be better than nothing. In most cases, however, the success of swaps depends on sovereigns repaying vulture funds in full.
Argentina negotiated two debt swaps with 92.4% of its creditors, giving them 30% of what they were originally owed. Thus far, Argentina has kept up its repayments. However, in a break with market practice, Argentina resolutely refused to repay the vulture funds, on the grounds that their claims are extortionate and their refusal to accept what was offered other creditors.
To comply with the US decisions, Argentina must therefore default on bond repayments. Argentina has three further choices: avoid the US clearing system (and the jurisdiction of the US courts) and issue new debt in its own currency; ignore the US courts; or repay the vulture funds in full.
The legal issues
The US decisions will have wide implications for international debt markets.
The court has ruled that a debtor such as Argentina must treat all its creditors equally. In practice this means that the face value of all creditor claims must be repaid simultaneously – no longer can an indebted nation pay off some of its debts while hiding when the vulture funds send the bailiffs round. Another change gives creditors the right to find out a sovereign’s global assets that can be attached to satisfy seizure orders.
Courts generally tend to stay away from intervening in contractual disputes involving sophisticated investors in financial market transactions. The courts take the view that such investors must take their own protections for investment risks. In sovereign bond disputes, courts have so far deferred to remedies specified in the sovereign bond contracts and market practice – the right to seize the commercial assets of a sovereign, the right to accelerated payments on default and negotiated debt swaps.
In the most significant move, the US judges have effectively decided to put themselves in charge. The supreme court’s ruling has established the use of judicial discretion to resolve contract disputes and debt crises. Judges, not markets, will decide what to do when a country doesn’t pay its debts. The unprecedented exercise of judicial discretion in customising a remedy to satisfy the claims of vulture funds is a game changer.
Uncharted territory
The Argentina affair has at least kicked off a necessary conversation on the regulation of sovereign debt markets. The debate has, however, been unhelpfully polarised, reflecting the oppositional dynamic of judicial decision-making itself. Argentina, backed by the rest of the world including the United States, Mexico and France, faces the vulture fund and the judges. It’s an interesting story full of dramatic rhetoric, but the focus on individual protagonists is misplaced – they’re just doing what you might expect under the circumstances.
The deeper question concerns the significantly increased role of the courts in sovereign debt markets. Unlike informal rules of “market practice”, the law is binding and legitimate. Market practice made debt swaps possible but must now give way to judge-made law – a law that is customised to benefit one particular vulture fund at a time rather than the collective interests of creditors affected by default, the citizens of the debtor, or the wider region. In the longer term, the new rules will make it harder for countries to swap their debts for bonds with more forgiving terms, as was conventional for most debtors (including Argentina) in the past. Fewer debt swaps will mean more prolonged debt crises.
The US Supreme Court decisions offer vulture funds a repayment option in the face of existing international protections that allow sovereigns to effectively have their assets protected from creditors. In the face of a “uniquely recalcitrant” debtor, the courts have created an option of intervening in the way that they have. The problem therefore lies in the deep structural flaws that place the courts in the invidious position of acceding to vulture funds gaming the system. But courts don’t exist to solve structural problems – or at least, they haven’t evolved that way. That is what politicians are supposed to be for.
A century ago, judicial interventions failed to deal with the insolvencies of indebted US railway companies. Sensing the limitations of judge-made law, politicians took matters into their own hands and created what became the Chapter 11 corporate bankruptcy law (Arthur. H. Dean, 1940-41). Today, we have a similar problem at the international level – and a similar intervention is required.
We need to build a political consensus behind the idea of a formal international debt resolution framework. No more ad-hoc decisions by judges. Things could be decided through a sustainable and transparent international sovereign bankruptcy process. This isn’t just a pipe dream – Nobel-winning economist Joseph Stiglitz is among those who have repeatedly proposed such a framework.
In the interim, Argentina continues to be effectively shut out of primary capital markets. In the medium term, expect a significant increase in litigation – the recent request for clarification of the US decision by Euro Bondholders is a case in point. And that’s not all. The US Supreme Court’s decisions in favour of the vulture funds may be justified by the need to maintain market confidence but, paradoxically, they seem likely to diminish the certainty and predictability attached to debt issued under US law.