Sovereign Bonds 

Sovereign debt: Curing defaults

The payout of $2.4bn from Argentina to Elliott Management spurred efforts to tighten the restructuring process
The numbers for each nation are the spreads in basis points for five-year credit default swaps © Getty
 
by: Robin Wigglesworth and Elaine Moore
At 8:13am in New York on April 22, about $2.4bn ticked into the bank account of Elliott Management, a fearsome hedge fund known for its dogged pursuit of countries that default on their debt.
The money came from Argentina, the final pay-off from Elliott’s 15-year legal crusade against the South American country. Elliott had led a band of creditors that sued Buenos Aires after it defaulted on $80bn of debt in 2001, culminating in a financial blockade of Argentina that resulted in another default in 2014.
This year, the reformist government of President Mauricio Macri resolved the debacle. In February, Argentina reached an accord with Elliott, a handful of other hedge funds and creditors that had refused to take its original punitive debt restructuring offering. The money was raised in April through the biggest bond sale — worth $16.5bn — by a developing country.
A saga that has captivated the sovereign debt world is finally over, yet economists and lawyers are now examining the broader implications. The suspicion is that the legal tactic successfully used by Elliott — and its eye-watering profit — could embolden other hedge funds to try to exploit countries in distress and make it harder for states to tackle excessive debt burdens.
“It’s a disaster for the world,” says Joseph Stiglitz, an economics professor at Columbia University and a Nobel laureate. “It sets an enormously bad precedent and will cause a lot of anxiety in the global financial system.”
Moreover, bankruptcies from countries such as Greece and Ukraine have exacerbated other faultlines that could complicate the sovereign debt restructuring process. This is an immediate worry, as states such as Venezuela and a host of others dependent on commodity exports are facing difficulties.
The financial system’s guardians have rallied in response to these concerns. The International Monetary Fund and finance industry bodies have spent the past few years overhauling aspects of the sovereign bankruptcy architecture. Yet it remains an open question whether the measures, such as beefed-up bond clauses, will be sufficient.

Dealing with creditors

When the Libertad, an Argentine frigate, docked at the Ghanaian port of Tema in October 2012, the captain and its 220-strong crew expected a brief, enjoyable goodwill visit to the west African state. But Elliott Management had decided otherwise.
Within a day of anchoring, Elliott’s lawyers had filed a claim against the ship as partial recompense for Argentina’s debts. Eventually a UN tribunal ruled that the Libertad was protected by sovereign immunity, allowing its crew to sail back home. But Elliott enjoyed much more success in the US courts.
All bonds boast an array of often boilerplate terms and conditions. Elliott argued that one called the pari passu clause meant Argentina could not continue to shun them while making payments to creditors who grudgingly accepted the 30 cents on the dollar offers made in 2005 and 2010 and held new “exchange” bonds.
Not only did Thomas Griesa, a US district court judge, agree with Elliott’s interpretation, he slapped an injunction against anyone helping Buenos Aires to avoid the order. In practice this left Argentina with the unpalatable choice between paying its nemeses or defaulting again. In 2014, President Cristina Fernández de Kirchner opted for the latter.
After Mr Macri’s more emollient government came to an agreement with Elliott and other creditors earlier this year, Judge Griesa lifted his injunction, the default has now been “cured” and Argentina rehabilitated. But the litigation could leave a significant legacy.
Many sovereign bonds have pari passu clauses, and Elliott’s financial bonanza could embolden other creditors to pursue similar tactics in the future, says Mitu Gulati, a law professor at Duke University. “I’m fearful this movie is not over. The potential returns are astounding and could create a whole industry of mini-Elliotts.”
Although every situation varies greatly, there are indications that creditors are beginning to take a tougher approach with countries. Franklin Templeton played hardball with Ukraine, and Gramercy, another US hedge fund, is now suing Peru over some of its old, long-defaulted bonds.
Jay Newman, a senior portfolio manager at Elliott and Argentina’s primary antagonist, argues that the hand-wringing over the impact of his successful action is wildly overdone. He points out that most restructuring proceeds relatively smoothly and highlights the sheer length of Elliott’s litigation as a deterrent against other firms pursuing legal remedies in the future.
“These situations can be resolved quickly and amicably if there is a willingness on both sides to sit down and negotiate,” Mr Newman says. “The lesson of Argentina is that litigation is not a fruitful course for countries or their creditors … Litigation will never be the primary course. Argentina is an aberration. It is the tail wagging the dog.”
Indeed, research by Elena Duggar of Moody’s Investors Service in 2013 found that most restructuring over the previous 15 years was resolved quickly and almost all had occurred without ligation from “holdout” creditors. In 34 cases, creditor participation averaged 95 per cent and deals were sealed 10 months after a government announced plans to restructure. Only Argentina’s case led to persistent litigation.
Argentina may be an outlier, but many other experts are less sanguine over the long-term impact. One of the reasons there has been little litigation is that most countries simply elect to pay off any holdouts — but crucially this depends on their number being limited. Even if few creditors have the legal nous, resources and sheer stubbornness of Elliott, the very fact that it was so successful could cause copycat litigation.
“Holdouts will now have something to point to,” says Mohamed El-Erian, chief economic adviser to Allianz. “I think restructurings will become much more contentious now.”
Moreover, the defaults of the likes of Greece, Ukraine and Jamaica have highlighted related problems. These include corralling creditors into an agreement, encouraging early dialogue with investors, the IMF’s own actions and the difficulties in assessing exactly when a country has gone bust. Most of all, countries have a tendency to delay debt workouts — worsening the challenges when reality finally bites.

Group action

Many of these issues are being tackled. In the wake of Greece’s crisis the IMF examined the sovereign debt restructuring process, and it has reconfigured swaths of its own framework. This includes scrapping a controversial exemption on its lending policy that initially allowed the institution to bail out Greece,without insisting on a debt restructuring.
But perhaps the most meaningful overhaul has come from the private sector, albeit with some cajoling from the US government. In April 2013, the US Treasury orchestrated an informal group of creditors, bankers, lawyers and governments to find a solution to the problem. Over the course of a year the “Sovereign Debt Roundtable” meetings were attended by representatives from multilateral institutions, major governments and the London-based International Capital Markets Association.
Bringing governments and the private sector together was difficult but vital, according to someone with knowledge of the Treasury’s thinking. “We knew both sides had to be involved from the beginning — nothing would have been agreed otherwise,” says one participant. “These are huge markets and huge changes. Everyone had to feel involved.”
By August 2014, an agreement was reached. ICMA published proposed new bond guidelines that clarified the wording of the pari passu clause to neutralise its legal importance, and urged a revamp of so-called collective action clauses designed to stymie the threat of holdouts.
CACs typically stipulate that if more than 75 per cent of creditors vote for a restructuring deal, then it binds all creditors. The clauses became more popular after Argentina’s 2001 default and these days, most countries — certainly developing ones — include CACs in their bonds. But they have one big weakness that creditors can exploit: they only work bond by bond, so if an investor manages to snap up 25 per cent of a security they can block its restructuring — something that hedge funds did with a clutch of Greek bonds in 2012.
Although the Greek restructuring was still completed — thanks to retroactively fitting CACs into local-law bonds — this rattled many government officials worldwide and made action imperative, according to Leland Goss, ICMA’s chief lawyer. “People were very, very frightened and concerned at the time. So as a result, something had to be changed in the global financial architecture,” he says.
In the immediate aftermath of the eventual Greek restructuring in March 2012, Brussels said all countries in the eurozone should include next-generation CACs that lower the voting threshold and crucially include “aggregation” to allow votes to bind across a country’s debt pile. ICMA expanded that by updating the bond issuance guidelines for all its members.
Take-up of the new “super-CACs” was swift. Within two months, Kazakhstan became the first country to introduce the features, followed by Mexico, one of the largest borrowers in emerging markets. Argentina’s jumbo bond sale this year includes the new clauses. Contrary to the worries of some governments, investors took the changes in their stride and the new debt showed no discernible difference in price. Even China is said to be considering rewriting its debt to show support for the new international framework.

Voluntary adoption

Other sore points are still being addressed. Many investors also want clauses that require timely disclosure and good-faith negotiations with creditors to be enshrined. So-called creditor committee clauses are under discussion at the IMF and an announcement is expected this year.
Yet these developments are hardly a panacea. ICMA’s guidelines are precisely that, and not every country has adopted the reworked terms. The changes are voluntary and some governments have simply chosen to copy their existing bond literature. Recent bonds issued by countries including Nigeria and South Africa do not feature the new clauses.
Moreover, neutered pari passu clauses and super-CACs will only appear in new bonds, leaving trillions of dollars worth of debt outstanding that could prove vulnerable.
Whether sovereign debt restructuring is in need of a more fundamental rethink will become more apparent in the coming years — with Venezuela likely to be the first and biggest test case.
“There has been a lot of progress, but it’s probably more incremental than we would have liked,” admits Sean Hagan, the IMF’s top lawyer.
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