Allen & Overy Sides with Pari Passu Pessimists

The global law intelligence unit of Allen & Overy, the London based global law firm, has prepared a white paper on the pari passu clause and the Argentina bond default.

This paper is just part of the voluminous commentary on the subject that has issued forth from law firms and academia since October 2012, when a three-judge panel of the U.S. Court of Appeals for the Second Circuit held that Argentina had violated the pari passu clause in its defaulted-upon bonds by making payments on the new [restructured] bonds without a ratable payment to the holders of the old bonds.

Allen & Overy’s white paper is among those that take a rather gloom-and-doom tone toward the issue. Personally, I don’t believe that the sky is falling around us, but the adjustments that market participants will make in their own situations as a result of the warnings of their law firms will themselves constitute an important pillar keeping the sky up.

Disruption and Uncertainty

At any rate, this paper contends that a narrow interpretation of the pari passu language is the “mainstream market understanding,” and that in this narrow/mainstream interpretation the language simply prohibits the contracting sovereign from “some legal or mandatory measure which changes the legal ranking,” something sovereigns are not in the habit of attempting at any rate.

A wider interpretation, such as that apparently adopted by the Second Circuit, is that the clause prohibits the sovereign from “making any unequal payments when they are in fact insolvent or even just in any kind of payment default.” That, the authors worry, could have disruptive consequences for the settlement efforts of sovereign issuers on the brink of default.

The disruption is perhaps compounded by uncertainty as to whether the Second Circuit really did adopt that wide interpretation. As the white paper also says, the court held that it was a combination of actions of the various branches of Argentine officialdom that violated the clause. The actions at issue included moratoriums on payments declared by the executive, a Lock Law enacted by the legislature, and statements in the prospectus for the new bonds. Thus, it isn’t clear whether the court even means that a single discriminatory non-payment would have been a pari passu violation by itself.

The white paper suggests the use of collective action clauses to “mitigate the problem of holdout creditors,” though it also warns that protection from this corner will not be comprehensive.  Collective action clauses provide that minorities are bound by the decision of a super-majority, typically either two-thirds or three-quarters. If that majority agrees to accept an exchange of bonds, the hold-out tactic is excluded.

But collective action clauses have their weaknesses. Holdout creditors can buy out a blocking quantity in a small issue. Few CACs at present “contain aggregation clauses allowing overall majorities across all issues to bind a single dissenting minority in one issue,” so by blocking agreement in a small issue, holdouts can “torpedo the whole process.”

Digression on Remedy

The white paper also raises the possibility that U.S. courts will “order specific performance by means of injunctions preventing discriminatory payments, with penalty of contempt of court if not complied with.” There is just a single brief reference in the white paper to that possibility, and that is as close as it gets to grappling with what is in fact the Big Issue in the continuing litigation of the issue in New York: remedy.

BNY Mellon, a non-party appellant, is making the case that its receipt and distribution of funds does not rise to the level of making it “active concert and participation” with Argentina’s defiance of court orders. After all, rule 65 of the Federal Rules of Civil Procedure says that a court injunction binds the parties before the court, their officers agents, employees, etc., and “other persons who are in active concert or participation” with the parties.

How much bite will the Second Circuit’s decision have? That depends in large part upon how its injunctions are construed, and especially upon whether that Rule 65 language is taken to include financial services firms that are simply seeking to carry out contractual obligations to a party when those obligations themselves were incurred prior to the injunction, the sort of thing that BNY Mellon in its briefs calls “passive conduct.”

Back to the White Paper

The Allen & Overy paper also reflects on the significance of New York law in the global picture. New York law is one of the “two great legal ‘public utilities’” in this area – English law is the other. If English courts take a different view from that of the Second Circuit on behalf of New York, this “could lead to undesirable arbitrage and destabilizing forum-shopping and litigation.”

The law firm advises market participants to be more particular about the language used going forward “and to introduce appropriate qualifications.” That would seem to be a key point.

My own guess, again, is that the markets will adjust to the Second Circuit’s reading and that the disruption will be less severe than contemporary pessimists imagine. First, they will adjust because new contracts will reflect the new understandings. Second, as to existing contracts, the alternative of English law (even with the possibility of arbitrage) will prove a mitigating not an aggravating factor. Third, the appellate courts will probably back away from any overly-draconian remedial rulings.

The weather report for coming weeks does not say “falling chunks of sky.”

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