Argentina’s Hundred-Year Bond and its Make-Whole Premium: A Spanner ...

Argentina is on the brink of attempting a restructuring of its sovereign debt.  And, of course, that has attracted the birds of prey.  An article in Bloomberg a couple of days ago (here) reported that potential holdout creditors had hired expert lawyers to examine the fine print in Argentine contracts in the hope of finding a vehicle to support their litigation strategies.

Assuming that it is not going to be long before Argentina is in full restructuring mode, my question is whether an unusual clause in one of the Argentine bonds, combined with a recent case out of the Southern District of New York, might interfere with the Argentine government’s restructuring plans?

The clause is the Optional Redemption provision in the $2.75 bn hundred-year bond that Argentina issued in June 2017, with the hefty coupon of 7.125%.  Optional Redemption clauses, as my co authors (Amanda Dixon, Madison Whalen and Theresa Arnold) discovered in an analysis of over 500 recent sovereign and quasi sovereign issuances, are rare creatures in this market.  Fewer than 20% of all the sovereign issuers use them. Some, like Mexico, are frequent users. But others, such as Argentina, have used them only on rare occasion.

Oversimplifying, these provisions typically allow the issuer to call the bonds at a supra compensatory amount (somewhat misleadingly called the “make-whole” amount).  Our data suggests that such provisions were largely absent from the sovereign market in the period between the mid 1990s and 2010.  Somewhere around 2010 though, Issuer Call provisions with their “make-whole” premia began migrating into the sovereign world from the high-yield corporate bond market.  Precisely why the Issuer Call provisions are set at a supra compensatory amount is something of a mystery to me (Marcel Kahan and I discuss the mechanics of these clauses here).

What I’ve heard from lawyers and bankers in the interviews that Marcel and I did for our piece (here) is that high-yield corporates sometimes need to retire their old bonds to they can escape onerous covenants (for example, to engage in a lucrative merger).  And to do that they are willing to pay a high amount – that is, a supra compensatory “make-whole” premium. In the sovereign context though, not only is there not going to be any lucrative merger, but the covenants are not all that onerous such that issuers would want to pay a big premium to get out of them.  But maybe there are countries that are think that their current borrowing costs are unduly high (e.g., the 7.125% coupon on Argentina’s 100-year bond) and that these costs will surely go down some day in the future.  That, in turn, will make the redemption option valuable to that optimistic issuer. And, maybe, like Argentina was in June 2017, the issuer will be willing to promise pay a high amount to creditors if conditions ever become so positive that it wants to retire substantial amounts of its high coupon debt. Alexander Hamilton certainly thought so in the Report on Public Credit in 1790 (here).  Things haven’t quite worked out for Argentina in the manner that they did for Hamilton and the US.  But a hundred years is a long time. 

Now, you might ask, why is an Optional Redemption clause relevant in the context of an attempted sovereign restructuring?  After all, an Issuer Call option and should only be relevant where the issuer chooses to exercise the option.  And Argentina is seeking to get creditors to take haircuts, rather than exercise its redemption option.  Remember, the redemption option typically requires the issuer to pay a supra compensatory amount (because it is intended to operate in a state of the world where things have improved so dramatically for that issuer that it wishes to retire the debt) – which is the opposite of the haircut that Argentina needs to impose currently (because things have turned terrible for Argentina).

The answer has to do with a New York case from late 2016, Cash America v. Wilmington Savings.  Drawing from a blog post that Marcel Kahan and I did for the Columbia Law School Blue Sky Blog a couple of days ago, here is the story of the case:

Bond indentures [for high-yield corporate issuers in the US] commonly contain what are called “make-whole” provisions that give the issuer of the bonds the option to redeem the bonds, at a premium over par. Bond indentures also contain an acceleration clause that gives bondholders the option, upon an Event of Default, to demand immediate payment of the principal amount and receive par. To reiterate, redemption is an option of the issuer while acceleration is an option for bondholders.

In Cash America [v. Wilmington Savings], the issuer was found to have violated a covenant in the bond indenture, thereby generating an Event of Default.  The court ruled that when the issuer engaged in a “voluntary” covenant breach, holders are entitled to receive as a remedy the amount they would have received upon redemption, that is a premium over the amount receivable under the acceleration clause.  [And that redemption amount was a supra compensatory “make-whole” amount].

The decision caused much consternation among numerous elite law firms. Transactional lawyers argued that the contract didn’t say anywhere, or even imply, that the bondholders were entitled to such a remedy. (For more detail on the case and the law firm responses, see here, here and here). As an aside, although we agree with the transactional lawyers that the Cash America court’s grant of the make-whole remedy to the bondholders was peculiar as a matter of contract interpretation, the court was arguably following Second Circuit precedent [the famous Sharon Steel v. Chase Manhattan case written by Judge Ralph Winter].

The implication of the foregoing, as the various law firm memos written in the wake of the Cash America case warn clients, was that bond issuers using the standard Optional Redemption provision (aka “make-whole” premium clause) should henceforth be forewarned that they might be liable for this payment if their triggering of an Event of Default sometime in the future were seen as “voluntary” by a court (see e.g., Glenn West’s blog post and this memo from White & Case).  The question to ask then is what the hell did the court in Cash America mean by the term “voluntary”.  Judge Furman’s opinion doesn’t explain. My guess is that the judge was thinking of a state of affairs where the debtor was insolvent and was being forced by the creditors into a bankruptcy proceeding.  After all, that seems somewhat involuntary. That’s not an adequate answer, but it is something.

But what about the sovereign context?  After all, sovereigns cannot be forced into a bankruptcy proceeding (there is none). Further, given that sovereigns can in theory always tax their people more to repay their debt, sovereign debt restructurings are in a sense always “voluntary”.  (Worse, sovereigns themselves frequently describe their their debt restructurings as “voluntary” – see here and here).  So, does the remedy given by the court in Cash America apply any time a sovereign (with an Optional Redemption provision) triggers an Event of Default along the way to seeking a “voluntary” debt reduction?

To conclude in the affirmative strikes me as wrong, and probably not what either of the judges in Cash America or Sharon Steel intended.  They, I think, were concerned about instances where a financially healthy issuer was trying to escape having to pay a redemption provision by causing an Event of Default and inducing creditors to accelerate and take par. And that is surely not the case with Argentina in 2020.  But I’m reading between the lines of those judicial opinions and that’s a fraught exercise.  A good litigator would not find it difficult to argue that the explicit language of the Cash America points the other way (for anyone who finds this implausible, it is worth recalling what happened in the pari passu saga). And if one reads the cases in that fashion, that then gives the holders of the hundred-year Argentine bond the basis to assert that they are owed a significantly higher amount than what other Argentine bondholders are owed.

From the Argentine perspective, that’s probably bad enough.  But the can of worms can be opened still further.  If the holders of the hundred-year bond have a plausible claim to a significantly higher payment than the other bondholders by virtue of the Optional Redemption clause in their bonds, this means that they will expect to be offered a premium over the others to get them to consent to whatever restructuring deal Argentina is offering. But if that is so, would that differential offer violate the “uniformly applicable” condition for the operation of the fancy new aggregated Collective Action Clauses in the post 2015 Argentine bonds that are supposedly going to solve the holdout problem?

The “uniformly applicable” condition requires (my emphasis) that “holders of debt securities of any series affected by that modification are invited to exchange, convert or substitute their debt securities on the same terms for (x) the same new instruments or other consideration or (y) new instruments or other consideration from an identical menu of instruments or other consideration.” The provision continues by clarifying that the uniformly applicable standard is not satisfied when bondholders are “not offered the same amount of consideration per amount of principal … as that offered to each other exchanging, converting or substituting holder of debt securities of any series affected by that modification.”

Strikes me that having to offer the holders of the hundred-year bond a special deal would violate the foregoing.  And that then means that the votes of the holders of this bond can’t be aggregated with those of the others, which in turn means that the power of the aggregated CACs to squash potential holdouts gets diminished.  And if other outstanding Argentine bonds have yet other idiosyncratic clauses that could mean that those holders also will want special deals. (Mark Weidemaier and I have talked elsewhere about the lack of clarity over what satisfying this “uniformly applicable” condition entails). 

Argentina has a history of agreeing to contract provisions that then bite it in the proverbial backside when it needs to restructure.  The infamous FRANs that Bloomberg’s Matt Levine wrote about are exhibit one (here). (Matt also has a delightful piece on the Cash America case, here).

As an aside, the Argentine century bond was issued in June 2017, over six months after the Cash America decision came down. That means that the lawyers doing the Argentine issuance would have known about the risk that the case posed for them should there need to be a restructuring.  Plus, this was not a standard boilerplate clause that the various parties might have ignored. It was a one-time use. And that means that it must have been negotiated over.  I’d love to know what the negotiation among the parties was about whether or not to put in place some corrective language to negate the implications of the Cash America decision.  In the corporate context, there were about a dozen bond issuances where such corrective language was inserted immediately after the Cash America decision came down. But investors refused to accept this corrective language after those initial dozen or so corporate deals (Marcel and I discuss this here). The sovereign context is different though, and the downside risks posed by the Cash America decision are arguably larger.