A Cautionary Tale: Argentina’s Pari Passu Debt Debacle

Mark Weidemaier & Mitu Gulati

Tim Harford of the Financial Times has a brilliant new podcast, Cautionary Tales (here). A recent episode, “Danger, Rocks Ahead!,” centers on the wreck of the Torrey Canyon, an enormous oil tanker manned by an experienced crew and captain. Sailing under clear skies, but under a deadline, the ship ran aground on an infamous reef, The Seven Stones, off the southwest coast of the U.K. Harford recounts the series of decisions leading to the disaster, each small misjudgment slowly reducing the margin of error, until none was left. The lesson for Harford is about path dependence. Having committed to a course of action, people often don’t react and adapt when new information reveals flaws in the plan. Thus the experienced Torrey Canyon crew drove their ship onto the rocks when it should have been trivially easy to recognize and avoid the looming catastrophe.

Okay – so this is perhaps not the only metaphor for Argentina, but it fits, and we wanted to mention the Cautionary Tales podcast to Credit Slips readers. Harford’s story about the Torrey Canyon also made us wonder whether Argentina’s debt debacle of 2001-2016 might offer a cautionary tale for the country’s current crisis. We think it does. In fact, one might understand the legal disaster that unfolded over 2001-2016 as the product of a series of misjudgments by Argentine officials. These misjudgments slowly reduced the country’s margin for error and gradually persuaded the U.S. federal judges overseeing litigation against the country that Argentina no longer warranted their sympathy.

We won’t recount the details of Argentina’s decade-long, and ultimately disastrous, battle with holdout creditors. The FT’s Joseph Cotterill recounted the entire saga at FT Alphaville, see, e.g., here), and Bloomberg’s Matt Levine wrote about the 2016 settlement (see here, here and here). We’ll focus instead on the mistakes made along the way.

A simple explanation for Argentina’s legal disaster is that a few U.S. federal judges interpreted an obscure term in Argentina’s bond contracts (the pari passu clause) in an unexpected way and fashioned a novel and unprecedented equitable remedy that ultimately forced Argentina to settle. There’s some truth to this story, but it focuses attention on the outcome—the ship hitting the reef—rather than on the series of missteps that turned that outcome from a remote possibility to a near certainty.

A more complete story needs to highlight the failure of various actors on the Argentine side to take some simple, cheap steps that might have avoided disaster. There were plenty of warning signs along the way. But Argentine officials repeatedly failed to take note and adapt.

Course Correction One:  Eliminate known risks (in this case, the pari passu clause from old bonds)

Argentina defaulted in late 2001. At that time, holdout creditors had just won one of their biggest ever victories against a sovereign debtor, Peru. The case was decided in the commercial courts of Brussels just one year before, in 2000, and it involved the same version of the pari passu clause that would doom Argentina ten years later. This was no obscure case. Nearly every observer of sovereign debt markets was aware of it, and it got major press coverage. Here is Felix Salmon writing about it in Euromoney in 2004—the year before Argentina conducted its first debt restructuring operation after the 2001 default. To be sure, many lawyers in the industry doubted that a New York court would give holdout creditors the same relief. (For interviews with lawyers in the industry, see here.) But the risk was well-known.

So, in 2005, when Argentina conducted its first exchange offer, the risk of pari passu related litigation was clear. Moreover, most of Argentina’s bonds had the same version of the pari passu clause that had tripped up Peru. Could Argentina have mitigated that risk? Easily. In offering to exchange new bonds for old bonds in default, Argentina could have asked participating creditors to vote to remove the pari passu clause from all bonds that did not take the offer. (They could have also done other things to defang the holdout creditors, like eliminating the waivers of sovereign immunity in the old bonds). The technique we are referring to is called the Exit Consent or Exit Amendment. And while relatively new in the sovereign world, it would have been very familiar to the restructuring experts who worked on the Argentine deal, since it had been used just a few years prior in Ecuador’s restructuring. (For background on exit consents and on Ecuador, see here and here). To do this, it would have needed only 50% of bondholders to agree. And the result would have been to significantly reduce—if not eliminate entirely—the risk of pari passu litigation.

This isn’t idle speculation. In 2005, creditors considering participating in Argentina’s restructuring were worried that holdouts would use litigation to demand a disproportionate recovery. They were so concerned that they sought assurance that Argentina would not offer holdouts a better deal. To ease their concerns, the country passed a law (the “Lock Law”; more on this later) barring future disproportionate payments to creditors who didn’t take the 2005 offer. It also included a clause in the new bonds (the RUFO—Rights Upon Future Offers clause) promising creditors that, if it offered holdouts a better deal before the end of 2014, it would offer the same deal to restructuring participants. In the end, Argentina made its foreign creditors an exchange offer at 30 cents on the dollar. Roughly 70% accepted (see here), well in excess of the 50% vote needed to strip the pari passu clause from holdouts’ bonds.

Why didn’t Argentina and its participating creditors—both of whom lost big in the end—do this? The Ecuador strategy of using Exit Consents was, in 2005, still new in the sovereign world. And some had criticized the strategy as too aggressive. So maybe the thought was that it was safer to take the conservative route. But the decision left Argentina exposed to a risk that eventually materialized. Worse, Argentina took other steps that significantly increased the risk.

Course Correction Two: Don’t formally subordinate creditors. More broadly, don’t pass laws that worsen your position.

As noted, Argentina passed the Lock Law in 2005 to assure creditors who participated in the restructuring that holdouts wouldn’t get a better deal. Even at the time, it should have been clear that this was a mistake that would only magnify the threat holdout creditors posed.

To understand why, it helps to know a bit of the history of the pari passu clause, which has made occasional appearances in sovereign bonds since the 1800s. (See here and here). Very few market participants understood the clause to require sovereigns to pay creditors on an equal basis in the context of a restructuring. Despite this, there was relatively little agreement about what the pari passu clause forbade the sovereign to do. However, the most prominent interpretation was that the clause forbade sovereigns to pass laws formally subordinating a subset of pari passu-ranking creditors. As eminent lawyer Lee Buchheit put it in a 1991 article in the International Financial Law Review, “The Pari Passu Clause Sub Specie Aeternitatis” (see here, and for a later piece by Buchheit, here).

If a sovereign intends as a practical matter to discriminate among its creditors in terms of payments, the pari passu undertaking will at least prevent the sovereign from attempting to legitimise the discrimination by enacting laws or decrees which purport to bestow a senior status on certain indebtedness or give a legal preference to certain creditors over others.

The moral for any sovereign borrower was clear: Although holdout creditors would surely argue for an even more expansive interpretation of the pari passu clause, nearly everyone agreed that the clause forbade the formal legal subordination of one group of creditors. If there is one thing a sovereign should not do in the context of a restructuring, it is… well, something like the enactment of the Lock Law.

As it turned out, the Lock Law was one of the key factors that the U.S. courts pointed to in justifying their decisions against Argentina in 2011 and 2012.

Course Correction Three: Engage, and don’t lose control of the narrative.

From the very beginning, Argentina drew criticism for failing to engage with creditors, and its 2005 restructuring garnered relatively modest creditor support. Still, for years, Argentina received a great deal of deference from U.S. courts. For example, federal judges rejected attempts by holdout creditors to derail the 2005 exchange offer, concluding that the restructuring was crucial to Argentina’s economic recovery and that holdouts—whatever the legal merits of their arguments—should not be allowed to interfere.

As its economy slowly recovered, Argentina was inevitably going to lose some of this goodwill. But Argentine officials compounded the problem, seemingly taking delight in expressing disdain for the U.S. judiciary. Examples include publicly insulting the judges, vowing in open court to defy their rulings, etc. At least until 2015, there was relatively benign story that Argentina could have emphasized to deflect judicial wrath: We want to negotiate and to resolve all remaining claims, but we simply need more time until the RUFO clause (mentioned above) expires in 2015. As long as the clause is in effect, no deal is possible, because we would have to offer the same terms to all restructuring participants. With that position established—the position of a relatively responsible, engaged borrower—it would have been easier to characterize holdouts (accurately) as seeking preposterously large recoveries. (For just one example, involving the so-called FRANs, notes with annual interest over 100%, see here.) Instead, Argentine officials lost control of the narrative. By 2012 at the latest, they had become the unreasonable ones.

The broader point is that the holdouts won only because the U.S. courts ultimately decided to go to extraordinary lengths to bring Argentina to heel. In subsequent developments, federal courts in NY have suggested that they will reserve such exceptional remedies for exceptional cases involving “recalcitrant” sovereigns. That term remains undefined, but there is no doubt that Argentina, circa 2010-2015, is the poster child.

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Martin Guzman, Argentina’s current economy minister and the person responsible for steering Argentina’s latest restructuring past the shoals, has himself studied the most recent Argentine restructuring debacle in depth (here). Hopefully, he will learn from the mistakes of his predecessors. An Argentine debt restructuring will be complicated enough without self-inflicted wounds.