One of the classic alpha strategies, the “vulture” or distressed-debt strategy, as applied to sovereigns involves an asset manager’s willingness to bet that it will eventually recover on non-performing instruments (usually bonds) issued by sovereign states: instruments that may unsurprisingly be purchased at a deep discount on face value after the default.
On Monday, July 23, the U.S. Court of Appeals for the Second Circuit heard oral arguments on an appeal from the Manhattan district court in litigation that is symptomatic of how such strategies work. It isn’t so much betting, after all, as it is wrestling. Or, if you will, a manager’s bet on its own ability in the wrestling area of contemporary litigation.
Not the London Games, but….
NML Capital Ltd. is pursuing a lawsuit against the Republic of Argentina in regard to bonds it issued in the 1990s and on which it defaulted in 2001. On October 20, 2010, NML moved to amend its complaint to add a claim for the breach of what is known as the pari passu clause in the issuing documentation. The legal Latin phrase pari passu means literally “on the same footing,” and such clauses are meant to protect the creditors/bondholders from involuntary subordination to new or existing classes of debt.
In 2005, Argentina put forward an exchange offer, allowing holders of the defaulted-upon bonds 25 to 29 cents on their dollar. Seventy six percent of the bondholders accepted this deal. The legislature also that year enacted the “Lock Law,” which carved this take-it-or-leave-it position in stone, prohibiting the government from conducting any sort of in-court, out-of-court, or private settlement with hold outs.
But in April 2010, Argentina temporarily suspended the Lock Law, and made a second exchange offer, this time offering to replace certain of the replacement bonds with a face amount equal to 33.7 percent of the defaulted debt.
On December 7, 2011, the district court in New York, Judge Thomas Griesa, granted partial summary judgment to NML and others with regard to the pari passu claims, holding that they prohibit any arrangement by which the holdout creditors (NML and its co-litigants) don’t receive payments while other creditors, not their senior, do. On February 23, the district court went further and entered an injunction against such payments. That is what Argentina appealed, and why the matter came before the appeals court in July.
The litigation is not just legally but diplomatically sensitive. The U.S. has filed an amicus brief that expresses the government’s concern that the district court ruling, if upheld, will render it impossible for a variety of countries in distressed circumstances to reschedule their debt.
Also, The Clearing House Association has filed an amicus brief, effectively acting on behalf of its member banks, arguing that the pari passu language there follows “standard language included in substantially the same form in numerous credit documents,” and contending that a decision upholding Griesa would upset “the long-understood meaning of these clauses in the market.”
Narrow Decision Coming
Intriguingly, TCH did not take a position on whether the Lock Law itself violated the pari passu clause. Its concern was that the district court’s order didn’t rest on the Lock Law, or any other respectably narrow ground, but on a broader view that paying the bondholders who complied with the earlier exchange without also paying the holdouts was in itself a breach.
In the wake of the oral arguments, Vladimir Werning, one of JPMorgan’s researchers for the Latin America Emerging Markets, offered a commendably clear brief statement about the range of likely results.
Werning, on the basis of the gist of the judges’ questions, contends that if the higher court upholds the district judge’s injunctions it will do so on a narrow basis, what he calls the “least compromising” basis, (that is, one that does not necessarily compromise other sovereign’s abilities to restructure) will; be one focusing on the lock law, which is a feature of the situation unique to Argentina.
It is not our purpose at AllAboutAlpha to take a side in the underlying argument. In general the vulture funds play a valuable ecological function in world markets. But this hardly implies that they don’t also sometimes misread contract language in their own favor — a common enough temptation.
I bring up this litigation because, as noted above, it is symptomatic. The strategy of seeking alpha from the distress of certain sovereigns works, when it does, precisely because the logic of mutually independent sovereign nations collides headlong with the logic of the global interlocked marketplace. In that collision resides the continuing irrationality, and the continuing inefficiency, that bright people like the ones involved in NML repeatedly exploit.
But here is a gratuitous prediction. The court will take the hint that TCH has offered. It will find (a) that pari passu has a fairly narrow significance as a consequence of long practice, and is not inconsistent with the sort of restructuring Argentina attempted here, but (b) it will either find that the country’s on-again off-again Lock Law has had the effect of involuntary subordination, and uphold the injunctions on that convenient basis, or it will remand the case for further Lock-Law specific proceedings.