Opportunities for distressed debt investors are diminishing as governments look to adopt a new approach to dealing with sovereign default, effectively removing vetoes blocking debt restructuring. Stefanie Eschenbacher asks at what can be learnt from Argentina's default.
Argentina has defaulted eight times since independence from Spain in 1816, most recently because the government of Cristina Fernández de Kirchner refuses to pay holdouts.
Two US hedge funds, NML and Aurelius Capital Management, which had bought distressed debt after the 2001 default at a discount, did not accept a haircut and now demand payment in full.
Fernández de Kirchner has vowed to never give in to the “vultures”, while the holdouts have gone as far as capturing an Argentine naval vessel, the Libertad, in Ghana in an attempt to get paid.
In 2005 Argentina restructured much of the $100 billion debt it defaulted on in 2001. It again restructed in 2010, when 92% agreed to settle for a third of what they were owed.
The South American country is now in default, even though it had been paying the holders of its restructured bonds.
US district judge Thomas Griesa had ruled that US banks can no longer transfer Argentina’s interest payments to the holders of restructured bonds – not until Argentina pays the $1.3 billion or so it owes to the holdouts.
Putri Pascualy, who specialises in global opportunistic, event-driven and distressed credit strategies, at Paamco, says after decades of litigation, Argentina has hinged on the interpretation of two words: pari passu.
“There is no clarity over what this equal treatment means,” she says of the current definition of pari passu. “The rights of holdouts are not clearly defined.”
The International Capital Market Association (ICMA) recently published revised collective action clauses and a new standard pari passu clause for sovereign bonds to facilitate future sovereign debt restructurings. It is up to the governments to adopt them. The collective action clauses allow a majority of bondholders, at least 75%, to agree changes in bond terms that will be legally binding to holders, including those who vote against restructuring.
The new standard pari passu clause also details the scope of its application, thereby reducing the risk of it being used as a basis for disrupting future sovereign debt restructurings. Leland Goss, general counsel at the ICMA, says if this had been in place in Argentina, the South American country would never have become the “mess” it is today.
Holdouts would have been forced to accept the terms the other 92% agreed on.
“The same court, even the same judge, would have to come out differently,” Goss says, adding that the new pari passu clause says there is no right to ratable payment. In other words, a country does not have to stop paying all other creditors because it is not paying the holdout creditors.
Argentina has become an inter-creditor equity problem because creditors who took the pain – the haircuts and the write-downs – years ago, or who accepted exchange bonds, are now suffering because of this ruling.
“The ruling is affecting other bond holders, the innocent ones that are not in dispute with Argentina,” Goss adds.
“The new default of Argentina is a real mess that has been disruptive for markets.”
The ICMA consulted extensively with the industry, Goss says, but it was about “finding a balance between being effective against the holdouts, while minimising the negative effects on investors” in all cases.
“These are powerful tools for the government and there is a potential trade-off for investors and creditors, because they are giving up some of their democratic rights that they would otherwise have had,” Goss says, adding that the ICMA made an effort to minimise this effect.
Goss concedes that investors could potentially be discriminated against, but, if so, a borrower’s future cost of funding might increase.
Rob Drijkoningen, co-head of emerging market debt at Neuberger Berman, claims
that there should be broad support for the proposal from mainstream investors.
He adds: “Those who are not involved in distressed debt or special situations, can focus on the fundamentals of investing, but the clauses would reduce the scope for holdouts to make their case and get a better pay out.”
Drijkoningen says the predictability and transparency appeal to mainstream investors, and that it is unlikely a significant premium will appear in bonds because of these clauses.
Kenneth J. Heinz, president of Hedge Fund Research, however, warns that the clauses would likely result in higher funding costs for issuers and less asset protection for bondholders.
Heinz says: “Argentina’s case is exactly the reason why investors should not accept these provisions in bond covenants; the now defaulted bonds were issued subject to the jurisdiction of the US court so they could not be restructured by a government with a history of default.”
Heinz says for the lack of that protection, the appetite for the bonds, at the time of issue, would have been much smaller and at possibly prohibitive coupon rates.
The expectation of bond investors is that the principal and interest will be repaid in full as agreed, but Heinz says the proposal likely undermines this expectation. Heinz predicts that issuers are likely to discriminate between bond issues that have or do not have these minority-rights covenants, and that those with protections that allow majority-determined restructurings will pay higher coupon rates.
“Investors will need to carefully monitor the other holders of the debt in the secondary market, considering the possible motivations and coalitions on investors, which comprise enough votes to allow or block a restructuring,” he says, adding that the complexity is likely to reduce retail interest and liquidity.
Stuart Culverhouse, global head of research at Exotix Partners, a frontier market investment banking boutique that specialises in illiquid bonds and loans, equities, structured finance and capital rising, says opportunities are diminishing for distressed debt investors.
“It sounds like there will be fewer opportunities and fewer avenues to pursue a holdout strategy,” he says. “There are not many of these investors anyway.”
No country has adopted the latest collective voting proposal by the ICMA. Goss says there is a first-mover problem with governments worried about an issuance going sour, not raising enough money, the deal costing more and a bad reputation. However, governments have started to change the clauses of new bond issuances. Goss says Belize made a slight change to its pari passu clauses that is similar to his proposal, and when Greece came back from restructuring it also issued a new bond with similar clauses.
Goss recalls how ten years ago, when the first collective action clauses were published, there was a period when governments waited. It was Mexico that made the change first, and Goss says many more followed.
“These clauses will minimise the scope for different interpretations in the future, but may not eliminate them entirely,” Culverhouse says. “There will always be legal ambiguity.”
There are also legacy bonds that do not have these clauses. Guy Stephens, director at independent UK wealth manager Rowan Dartington, recalls earlier defaults by Argentina.
The first bond, issued in 1824, was meant to have a lifespan of 46 years, but Argentina defaulted within four years. Stephens says the ensuing dispute with creditors took 29 more years to resolve.
“What is clear is that the Argentinean government were slow to act and should have negotiated with the holdouts much earlier than they did,” Stephens adds.
The latest default is different from the previous ones in the sense that Argentina can pay and wants to pay, just not the holdouts. In recent weeks, Argentina has therefore passed a questionable law that would allow holders of foreign bonds to swap their bonds into local bonds and get paid in Buenos Aires.
“Argentina is making things up as it goes along,” says Culverhouse.
Investors would rather get paid in Buenos Aires than not at all, but Culverhouse says the risk for those that participate in this swap is that they could fall foul of the injunction themselves because there is an element to the injunction that others cannot allow Argentina to evade the ruling.
“Those who participate in this swap, be they bond holders or banks or anybody else that helped, could be held up in court and held in contempt,” Culverhouse says. “I cannot see any international investor wanting to do that.”
Pascualy says she shares these concerns and adds that Argentina has shown that it is not willing to follow the rules.
“Investors generally feel that they need the bonds to be issued under US or UK law for better protection of creditors,” Pascualy says. “How are they going to behave when there is even less protection for creditors, which is going to be the case if bonds were issued under their own law?” Culverhouse says the default raised questions over Argentina’s policy framework and unpredictability, which one would expect to unsettle foreign investors. This has not happened, yet.
Elections in Argentina are due October next year, and many foreign investors have placed hopes in a new government.
NML and Aurelius Capital Management have not responded to requests for comment.
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