Published December 11, 2012
LONDON – A legal clause as the key to smoothing future debt restructurings could be undermined by a U.S. court ruling that Argentina must pay creditors holding its defaulted debt.
The case has implications for emerging markets, source of protracted and painful past defaults, and for Europe, where the rules setting up the euro zone's bailout fund state that government bonds must carry Collective Action Clauses from 2013.
Known as CACs, the clauses make a restructuring binding for all creditors if agreed by a specified majority -- usually 75 percent. They are intended to eliminate the risk that some investors will shun offers and take legal action to squeeze cash from the debtor, often dragging the process out for years.
But 'Argentina vs. NML Capital' revives the threat that such holdouts will stall future debt restructurings. The U.S. court ruling upheld the principle of pari passu, meaning debtors cannot pick and choose between creditors.
In Argentina's case, that means the hedge funds which brought the litigation, and which refused to participate in two debt restructurings accepted by 93 percent of bondholders, must be paid what they are owed alongside those who did take part.
That has galled investors who took a 70 percent write-down on Argentine debt during the 2005 and 2010 swaps. The Argentine debt did not have a CAC, but the ruling could make it harder to secure the majority needed to trigger CACs in future.
"Such a ruling creates a big incentive to be a holdout going forward," said Bart van der Made, lead portfolio manager at ING Investment Management, which swapped its Argentine bonds.
"If you think there's a judge waiting around the corner who says you will be paid in full and with past due interest -- well, in that case, everyone will hold back and you won't hit the 75 percent approval rate required to (trigger) the CAC."
As the process drags on, more interest accrues, pushing the debt up further and impelling the borrower to concede more to creditors - some of whom may have bought their debt at vastly discounted prices - to secure a deal.
"In a new-type restructuring people may get extreme in their demands," van der Made added. "If a country comes with a proposal, bondholders will have a strong hand and could make it very hard for a country to get the resolution it needs."
Perhaps emboldened by the Argentine case, hedge funds last week proved reluctant to participate in a Greek bond buyback, the timetable for which had to be extended after Greece initially fell short of its target despite generous pricing.
Greece retroactively inserted CACs into its domestic bonds to enable a successful swap in March, but still has 6.4 billion euros of foreign law bonds, the terms of which can't be altered.
Some of these will have been tendered in the new buyback, but many hedge funds say they plan to hold on to their Greek debt in expectation they will be repaid at par later.
Analysts at JP Morgan advised Greece prior to the buyback to enforce its CACs, estimating that by doing so debt relief would be double what it would get if it allowed some creditors to hold out.
If the swap is voluntary, "the burden of achieving the 30 billion euro participation will likely fall mostly on Greek banks, and expectations will rise that the remaining bond holders will eventually be paid in full," JPM said in a note.
That happened last May when Greece, spooked by the prospect of lengthy legal battles, paid 435 million euros to bondholders who had refused to exchange during an earlier swap.
CACs have been included for nearly a decade on sovereign bonds issued on international markets -- a 2008 Duke University study found them in over 90 percent of bonds under U.S. law.
Emerging market countries, some of which have bought back billions of dollars of older debt and replaced it with CAC bonds, have expressed concern about the ruling's impact.
Alexandre Tombini, the central bank governor of Brazil, itself a past debt defaulter, has said the rulings against Argentina set a bad precedent.
Hedge funds, however, are excited at the prospect.
"I think you'll look back in two or three years' time on this crisis and the Argentine U.S. court decision ... will prove to be a very, very interesting juncture - a very strong strengthening of a creditor's hand and a weakening of governments," said Lee Robinson of hedge fund Altana Wealth.
Funds that specialize in buying up defaulted debt at a fraction of face value and then pursuing the issuer for repayment at face value are sometimes known as vulture funds, although they argue they are upholding creditors' rights. They can be aggressive in trying to secure payment: the two hedge funds suing Argentina recently seized a naval ship off Ghana.
Recalcitrance has been profitable in the past, with countries from Peru in 2000 to Greece in 2012 having paid holdouts rather than do battle in court.
Argentina says its own law prevents it from paying holdouts, however, making compliance with the U.S. ruling illegal.
One creditor group does still enjoy preferential treatment during restructurings, however: the official sector, including the International Monetary Fund, although rating agency Moody's notes this status is conferred by practice rather than law.
"The court ruling, which strengthens the pari passu clause in bond contracts and stipulates equal treatment of creditors, could potentially raise questions about the "senior" status of official sector lenders," Moody's said.
(Additional reporting by Laurence Fletcher; Editing by Catherine Evans)