THE ARGENTINE 2014 SOVEREIGN DEFAULT CAUSE AND CONSEQUENCES

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1 Opinion Article 31 st July 2014 THE ARGENTINE 2014 SOVEREIGN DEFAULT CAUSE AND CONSEQUENCES EXECUTIVE SUMMARY UWE BOTT On July 30, 2014 Argentina defaulted for the second time in 13 years on its sovereign bonds. In this case, the default was triggered by a court case won by so-called holdout investors, who had refused to participate in the restructuring agreements of 2005 and These restructuring agreements resulted in the issuance of so-called exchange bonds by Argentina for bonds it had defaulted upon in Approximately 91% of investors participated in these exchanges. However, some investors did not, among them two major hedge funds in the U.S., NML Capital and Aurelius Capital Management. These funds insisted in full payment and sued the government of Argentina in the New York court system for such payment. The original bonds were governed by New York law. In November 2012, a New York judge sided with the plaintiffs. In his decision Judge Thomas Griesa also stipulated that the exchange bondholders could not be paid by Argentina s trustee until the plaintiffs had received full payment on their bonds plus interest. The decision was subsequently upheld by the U.S. Court of Appeals. In June 2014, the U.S. Supreme Court refused to hear the case, effectively making the earlier decision final. The next semi-annual payment on Argentina s exchange bonds was due on June 30, While Argentina deposited the interest payments due at the trustee, Bank of New York Mellon (BNYM), Judge Griesa s order prevented BNYM from distributing these payments to the bondholders, because Argentina continued to refuse paying the plaintiffs. In practical terms, Argentina, therefore, defaulted on June 30, 2014 on its restructured bonds. A grace period of 30 days was granted. No agreement was reached and Argentina formally defaulted on July 30. BACKGROUND In December 2001, the Republic of Argentina defaulted on approximately $100 billion in sovereign debt. At the same time, it put in place a debt moratorium in order to negotiate a restructuring of defaulted bonds with its bondholders. In 2005 and 2010 respectively, some estimated 91% of outstanding bonds were exchanged in a bond swap between Argentina and its bondholders at an estimated 70% discount. 1

2 In accompanying legal documentation to these exchange bonds, Argentina stipulated that it would not make any payments to so-called holdout investors, who had not participated in the bond swaps or that exchange bondholders would receive the same terms as holdout investors should Argentina make such payments. This clause was also referred to as the Rights Upon Future Offers (RUFO). Several hedge funds, which had not participated in the exchange, subsequently sued the government of Argentina for full payment. THE U.S. COURT COMPONENT In February 2012, Judge Thomas Griesa of the United States District Court for the Southern District of New York ordered: That the Republic of Argentina pay the plaintiffs (various hedge funds holding the original bonds, including NML and Aurelius Capital) concurrently or in advance of making scheduled payments to the holders of the exchange bonds. That any paying agent or trustee for the exchange bondholders, in this case primarily Bank of New York Mellon (BNYM), must not act in violation of his order. In other words, BNYM was not allowed to make payments on behalf of Argentina to the exchange bondholders, if Argentina failed to obey the judge s order. On October 26, 2012 the United States Court of Appeals for the Second Circuit upheld the decision of Judge Griesa, but asked that he clarify the formula, by which holdout bondholders were to be paid and how paying agents/trustees were to meet their obligations as trustees to the exchange bondholders and not, at the same time, violate the judge s order, should Argentina fail to make payments to holdouts. On November 21, 2012 Judge Griesa ordered Argentina to make payments of $1.33 billion into an escrow account until further appeals in the United States were exhausted. Such payments had to be made by December 15, Argentina failed to do so. The judge also noted that the paying agents/trustees were obliged to ensure that Argentina not break U.S. law. The case returned to the Court of Appeals and was upheld in February Argentina appealed to the U.S. Supreme Court. The Supreme Court decided in June 2014 not to hear the case affirming the decision of the Court of Appeals and hence Judge Griesa s original order. Legally speaking, this was not surprising. The Republic of Argentina had largely defended itself against any judgments in favor of the holdouts by claiming sovereign immunity. However, the U.S Department of State formally endorsed the restrictive definition of sovereign immunity in This doctrine basically stipulates that a foreign government is only protected from lawsuits in the U.S. as long as it has acted in its role as a sovereign. Such sovereign immunity does not exist, however, when the foreign government has acted in a commercial role. This position was codified in the U.S. Foreign Sovereign Immunities Act of 1976 and, finally, successfully tested at the Supreme Court in its so-called Weltover decision of In that decision, the Supreme Court decided that the definition of commercial depended on the nature of the transaction, not on its purpose. For example, the nature of issuing bonds is considered commercial, while the purpose of a foreign government to raise debt may be 2

3 sovereign, for example to finance domestic defense. Since only the nature of the action counts, a sovereign government generally may be sued in a U.S. court and cannot claim sovereign immunity in cases of debt default. With regard to the aspect of enforceability of Judge Griesa s order vis-à-vis third parties, the Court of Appeals had indicated in its October 26th decision that it required further explanation from Judge Griesa because of some concerns with regard to the role of intermediaries, such as BNYM. Judge Griesa somewhat elaborated on his earlier decision with regard to such intermediaries. This portion of the suit was probably the most controversial among U.S. lawyers. In fact, the Federal Reserve Bank of New York had filed a so-called amicus brief in support of Argentina, particularly because it was gravely concerned with the operability of the U.S. payment system. The U.S. Uniform Commercial Code (UCC) would seem to protect intermediaries from being put in an impossible position. In this case, BNYM could not violate the Judge s order because it would find itself in contempt of court with serious pecuniary consequences. By complying with the Judge s order, BNYM is now potentially exposed to lawsuits filed by the exchange bondholders. However, the U.S. courts came to the conclusion that the legal obligation of Argentina to pay the holdout bondholders would be unenforceable unless intermediaries were forced to comply with the Judges orders. THE UK COURT COMPONENT In 2003, NML filed its first suit with Judge Griesa demanding that the Republic of Argentina pay principal and interest on two global bonds held by NML. On May 11, 2006 Judge Griesa awarded NML $284 million. In anticipation of that judgment, NML had filed a separate suit at a different U.S. court to attach certain Argentine properties in the District of Columbia so that NML could collect once it had been awarded a judgment. The U.S. District Court of the District of Columbia rejected this socalled pre-judgment attachment, because it argued that the Argentine properties were used by Argentina for the purposes of exercising its sovereign authority and not for commercial use. In order to pursue Argentine assets in other jurisdictions, NML filed suit against Argentina in the United Kingdom, among others. The Supreme Court of the United Kingdom, the country s highest court, ruled in favor of NML in July Its ruling is significant, because it too supported the concept that a sovereign bond issue is a commercial activity and not protected by sovereign immunity and that as such a judgment against Argentina in a U.S. court was considered enforceable in the United Kingdom. NEXT STEPS Unless a solution is found to this stalemate, it is likely that the holdout bondholders will seek to attach Argentine state assets held abroad to satisfy their claims. However, this is not an easy matter, because such assets that belong to Argentina as a sovereign such as embassies and consulates cannot be confiscated. At the same time, assets such as airplanes that belong to state- 3

4 owned Aerolineas Argentinas are unlikely to be considered sovereign assets and they could be potentially attached. There is great legal uncertainty about this. At this point, there are apparently discussion between Argentine banks and the holdout investors. Argentine banks are supposedly offering to buy the claims from the holdouts. On the surface this would not violate the RUFO clause. However, total claims by holdout investors who did not participate in the plaintiffs lawsuit, but would be entitled to full payment on their holdings, amount to an estimated $15 billion. It is unclear that Argentine banks would be able to support buying such claims as well. Another option is that the Argentine governments continue its negotiations without haste. This is possibly the most likely scenario, because the RUFO clause expires at the end of In other words, if the Argentine government were to make holdout investors an offer at the beginning of 2015, exchange bondholders would no longer be entitled to the same terms. Currently, the estimates of RUFO entitlements range anywhere between $200-$500 billion, clearly an unsustainable amount for Argentina. In any event, the Argentine economy will likely go deeper into recession, inflation will rise even further and the long-term prospects for Argentina are more clouded than ever. The country s exploration and exploitation of the vast shale gas fields of Vaca Muerta greatly depends on foreign investments and technology. In the most recent past, Argentina has confiscated assets of the Spanish oil company Repsol. That confiscation alone led to a cooling of relations with oil and gas companies. At this point, companies such as Chevron might fear that their assets, if deployed in Vac Muerta, may also be confiscated by Argentina in retaliation for potential attachment of Argentine state assets by the holdout investors. This creates great uncertainty to the very fragile Argentine economy. INTERNATIONAL IMPLICATIONS The media have spent much time on the implications of the U.S. courts decisions for future restructuring agreements. However, this is to a large degree hyperbole. First, during many sovereign restructuring agreements, governments simply decide to fully pay holdouts. Greece did so during the recent Eurozone crisis. Second, many sovereign bonds now contain so-called collective action clauses. These clauses state that certain supermajorities of bondholders may agree with a struggling sovereign on a restructuring that would become binding for all bondholders. A more serious feature of this legal dispute is, however, that it appears that U.S. and U.K. courts are increasingly willing to claw back creditor rights. For example, private creditors during the restructuring of Greek bond debt openly displayed their disapproval of the assumed preferred creditor status of public sector creditors to the Greek government, such as the German or other European governments or the International Monetary Fund. Over the next few weeks, barring a surprise agreement with the holdouts, the International Swaps and Derivatives Association (ISDA) will determine whether the exchange bonds are actually in default. This would be considered a credit event and trigger credit default swaps (CDSs) on this debt to be exercised. A new round of debt restructuring would be necessary. 4

5 Finally, there appears to be material exposure by Spanish banks to Argentina. The Spanish banking system has been much weakened by the Eurozone crisis. It is unclear to which extent Spanish banks might be vulnerable, but given the fragility of the Spanish financial system and the country s economic recovery, any crisis might once again raise the specter of uncertainty within the Eurozone. ARC Ratings will continue to monitor all developments and keep investors abreast of its interpretation of events and their consequences. Disclaimer This is view of Uwe Bott, ARC's Chief Ratings Officer, and does not represent those of ARC. 5