What happens when sovereign debt goes bad? In the corporate world, debt contracts are subject to bankruptcy and liquidation laws. But no such internationally recognized mechanism exists following sovereign default. As a result sovereign-debt restructuring occurs on an ad-hoc basis, meaning debtors and creditors come together to form specific case-by-case arrangements. Recent legal rulings in the Argentine debt saga, however, suggest that even this tenuous ad-hoc resolution system may now be unattainable.
On December 23, 2001, with Argentina in the thick of an economic, political and social crisis , the country defaulted on over US$100 billion in bonded debt. Over the next ten years, Argentina successfully restructured 93 percent of that debt. But seven percent of bondholders—typically hedge funds that purchased the notes following the default when they were essentially worthless—refused the restructuring. These hedge funds went to court, demanding full payment.
On November 21, 2012, US District Judge Thomas Griesa decided in favor of holdout plaintiffs, led by Elliot Management, and ordered Argentina to pay them US$1.33 billion. There is nothing particularly unique about holding out. In fact, over the last 20 years a highly experienced, very well-funded group of hedge funds have specialized precisely on this tactic, and it has been used to successfully capitalize on debt crises in Brazil, Peru, as well as in African and European countries.
What makes the Argentine case unique is that Judge Griesa legally blocked any further payment on restructured debt unless Argentina simultaneously paid the holdouts. So, at least in New York, unless Argentina pays the holdouts the full amount, they cannot pay anyone at all. Perfectly willing to pay the restructured bond holders, but unable to pay the holdouts, Argentina has since been forced in a very unique default.
Panel discussion on the Argentinas Sovereign Debt crisis featuring: Sergio Chodos (Center Left), Executive Director of the IMF, Cecilia Nahon (Center Right), Argentine Ambassador to the US with Samuel George (Right), GED Project Manager
This ruling throws off a delicate balance between sovereign debtors and sovereign creditors.
Even if you are not inclined to cry for Argentina, the truth is this outcome could negatively impact the future of sovereign-debt restructuring all over the world. For the last 30 years, sovereign debt restructuring was based on upon symmetric negotiations between debtors and creditors. Each side had reasonably balanced advantages and disadvantages from a bargaining perspective that ultimately led both to the table to hack out an agreement everyone could at least live with.
Lenders recoup a degree of their investment, and borrowing countries can shed debt overhang. Nobody loves it, but everyone can move on with their lives.
So what was that balance? The key complication of sovereign debt is that is very difficult to enforce. The widely accepted notion of sovereign immunity holds a state exempt from civil suit or criminal prosecution; it protects most public assets both at home and abroad, regardless of any court’s ruling.
A foreign judge can come to any conclusion under the sun—the question is how such a ruling could be enforced against a foreign, sovereign nation.
By the 1980s, the uneasy balance between creditors and borrows in default began to take shape. It became easy enough for lenders to get a US judge to rule against international defaulters. As Lee Buchheit, perhaps the world’s leading expert on sovereign debt, likes to explain, these judges are not economists, they are not necessarily financial or international experts. They have been trained to enforce the law and a bond is contract. They will ask a simple question: “Did you borrow the money? Yes? Ok, well, then you have to repay.”
So it became easier for creditors to get a favorable judgment, but again, with no bankruptcy court, it remained very difficult to collect. Creditors had a ruling, but they had no money. Meanwhile, the state could avoid payment, but would remain in default, an outcast from the international financial community, unable to pursue a clean slate.
Each side had advantages, and each side had weakness in relatively equal amounts. Over the last 30 years, this delicate balance has forced the participants to the table to work out a debt restructuring scheme. This was not a particularly stable system to begin with. It did not rely on binding legal findings, but rather on a delicate interplay between two poker players with mediocre hands
But it was the system we have been using and the 2012 US District Court ruling could throw it to the wind.
Given the ruling, according to a Brookings Institute report, “Potential holdouts have been handed a much better enforcement technique than they had in the past.” On the one hand, Judge Grieas’s ruling implies that holders of stressed sovereign bonds may eventually cash in the securities at face value. This would diminish the incentive to accept a haircut: Lenders will not accept a swap at market value if they think they can hold out for full face value.
On the other hand, this development suggests that if you do accept a haircut—if you as a lender do agree to restructure debt—holdouts could be able to subsequently block your ability to receive payment. So even if any given investor does not have the resources to pursue a lengthy legal battle against a country in default, there is now more incentive to hold out anyway, let others fight the legal fight, and cash in for full value subsequently.
Such trend would only prolong current any forthcoming sovereign debt crises, making it more difficult for debt-plagued countries to reemerge as stable and reliable players in the global financial system. This is a particular concern in the eurozone, which is not built to survive a sustained default by a member country—and where holdouts have already emerged as a threat.
No immediate solution in site
Many have trumpeted Collective Action Clauses that are now often included in international debt as a potential counterweight to balance the scales. These clauses, common in New York-issued bonds since 2005, allow a qualified majority of bondholders to enforce a write-down for all bondholders—thus limiting the influence of minority holdouts. So theoretically, if Argentine bonds had CACs, the 93 percent of bonds holders that accepted the haircut could enforce the swap on the holdouts.
This is an imperfect solution. On the one hand, as we have seen in Europe, firms specializing in holding out can obtain enough stressed debt to block the execution of CACs. If you need a 90 percent bondholder participation to enforce collective action, holdouts can block any action by obtaining more than ten percent of the debt. More fundamentally, however, the fear is that bond holders will be less likely to enforce the collective action clauses at all, precisely because they feel they can eventually hold out for full payment.
Any legal mechanism to adjudicate sovereign debt appears years away. On December 6, the United Nations voted in favor of a resolution to create a global bankruptcy process.
But there is no clear reason to believe the UN will be more successful than IMF attempts to build one in the 2000s. The bottom line is that many countries are still reluctant to cede that much legal autonomy to international organizations.
As it stands right now, it is tough to pick out a winner.
Buenos Aires remains outside looking in on international markets, while Argentine firms and sub-sovereigns face higher borrowing costs. None of the bond holders—restructured or holdout—are getting paid. Even New York could come out a loser in all of this. The city has been the go-to spot for issuances of international debt, but some wonder if countries wont think twice about this after a single New York judge steered a country of 40 million into default.
These are the most immediate consequences. But if we cannot find a solution to the quandary of sovereign debt, the biggest losers could be countries not even on our radar right now that find themselves stuck in a debt crisis from which they cannot emerge.