May 22, 2013 8:40 pm
Wins by hedge funds prompt debate on sovereign restructuring
Gunboats used to be the customary penalty administered by the world’s great powers to smaller countries that reneged on their debts. But, for much of the past century, states have been able to default with near impunity.
That began to change in 1994, when Kenneth Dart, the buccaneering heir to a foam-cups empire, launched an audacious lawsuit against Brazil and its $40bn debt restructuring. The secretive US investor technically lost but still walked away with a small fortune after Brazil elected to keep serving the debt. His success helped spawn a type of investor often denigrated as “vulture funds”.
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These investors, more politely called “holdouts”, have recently notched several stunning victories over countries from Greece to Argentina, which has shifted the balance of power away from countries and in favour of their lenders.
Concerned that an imperfect but functioning sovereign debt restructuring system could now be disrupted by emboldened hedge funds, the International Monetary Fund is considering how to reform the process. Later this week it will publish a paper and minutes from an executive board discussion on the subject.
The IMF has tried – and failed – to introduce reforms before. In the wake of Argentina’s calamitous default in 2001 the Fund proposed a Sovereign Debt Restructuring Mechanism, or SDRM, envisaged as a kind of bankruptcy court for countries, enshrined in the statutes of the Fund.
The initiative was shot down by the US – the biggest IMF shareholder – and has since languished. This is largely due to the fact that the reigning system has looked solid. Countries enjoy an almost impregnable shield of sovereign immunity that makes suing them a daunting proposition, and enforcing judgments nigh-on impossible. That has encouraged most creditors grudgingly to agree to take losses.
“You can sue countries until the cows come home, but it’s very difficult to get any money,” says Whitney Debevoise, a partner at Arnold & Porter, the law firm, and a former US executive director at the World Bank.
Indeed, holdout creditors – typically but not always hedge funds – have mostly proven a frustration, but not an impediment to successful restructurings. Given the annoyance their lawsuits can cause, most countries elect to pay them off. Argentina is the exception, but has been locked in the US courts and out of international bond markets for the past decade.
Key dates in sovereign debt restructuring
1976-78: US and UK pass state immunity acts that open the door for suing countries that acted as “commercial activities”, a vague term that was left undefined but implied the inclusion of debt issuance.
1985: A US bank refuses to join Costa Rica’s restructuring. It successfully sues, but is pressured into a settlement.
1992: US Supreme Court rules that countries can be sued for defaults on debts issued under US law.
1995: Investor Kenneth Dart sues Brazil over its debt restructuring. The US investor eventually loses but still makes a small fortune, and helps usher in the modern era of “holdout” creditors.
2000: Peru is forced to repay Elliott Management in full after the hedge fund uses the pari passu equal treatment for all investors argument for the first time.
2002: Argentina’s $100bn default spurs the International Monetary Fund to propose a mechanism for sovereign restructurings, but the initiative is killed by US opposition.
2011: Greece completes the biggest debt restructuring in history, but pays holdouts in full.
However, the past year has revealed several small but important chinks in the sovereign armour, causing many lawyers and officials to advocate an overhaul of the system. Greece was last year able to impose gouging losses on the holders of its domestic debts, but hedge funds and investors like Mr Dart were able to amass large enough stakes in international Greek bonds to block their restructuring. Athens has proven reluctant to take on the holdouts in court, and has so far elected to repay them in full.
Perhaps most importantly, hedge funds led by Elliott Management have recently scored several big victories in their long-running legal war against Argentina. Elliott is run by US billionaire Paul Singer, a cerebral lawyer who has turned Mr Dart’s protean holdout strategy into an art form.
Elliott has successfully argued in the New York courts that a clause in Argentina’s debts called pari passu (or “equal step”) meant that Buenos Aires could not continue to pay its restructured bondholders without paying Elliott and its partners. This opens up a potentially powerful weapon to use against defaulting countries.
The case continues, but experts fear that its cumulative effect and the sight of Greece paying hedge funds in full could inspire other creditors to hold out for a better deal in future – and turn a nuisance into something more problematic.
Litigation is rare, but already on the rise. A recent German study tallied only 108 creditor lawsuits between 1976 and 2010, but more than half of those have been filed since 2000. The paper also concluded that lawsuits are increasingly being filed by hedge funds, who typically sue for longer and for bigger amounts.
“Holdout creditor behaviour is infectious, and will become more common if people think they have a stronger hand to play against sovereigns,” says Lee Buchheit, a prominent lawyer at Cleary Gottlieb, a firm that has represented almost every country that has restructured in the past two decades, including Greece. His firm represents Argentina in its case against Elliott, but Mr Buchheit is not involved.
The question is what to do. “In the G20, the UN and the IMF board everyone realises that something needs to be done, but there is no consensus on what,” says one public official.
“A lot of ideas come along, get discussed and get some traction, but suddenly die when the counter forces are too big,” Mr Debevoise points out.
Many officials and lawyers argue that the current system still works, and will continue to do so despite recent events. Others advocate relying on a beefed-up contractual approach to solving any fallout from Europe and Argentina, such as using bond clauses rather than statute.
But some have started to champion a resurrection of the SDRM, or at least aspects of the initiative. “If it’s too grandiose it has no chance of happening, but a minimalist approach has a chance,” says Mr Buchheit.
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