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Ukraine Struggles to Restructure Its Sovereign Debt

The fallout from Argentina’s default last year is making it harder for Ukraine to restructure its debts.

When Argentina went through its second debt default in a little over a decade last year because of a run-in with the U.S. legal system, many experts warned that the case would have negative repercussions for a number of other sovereign borrowers. Ukraine is about to discover whether those concerns are well placed.

Kyiv is seeking to reach an agreement with its international creditors to trim payments on its outstanding debt by $15.2 billion over the next three years. Such a reduction is required to win a fresh tranche of aid under a $40 billion bailout program agreed to earlier this year by creditor governments and the International Monetary Fund.

Unlike most sovereign borrowers that have diversified their sources of funding, the bulk of Ukraine’s external, private-sector debt is held by just four investment managers: BTG Pactual Europe, Franklin Templeton, T. Rowe Price and TCW Group. Those firms, which own $8.9 billion of Ukraine’s $23 billion outstanding debt, have formed a creditor committee to defend their interests. They say they are unwilling to accept a principal reduction in the value of their bonds, but they have reportedly suggested extending maturities and offering concessions on interest rates. A proposal to postpone interest payments in return for guarantees from Kyiv was rejected by the Ukrainians in May.

Ukraine’s Finance minister, Natalie Jaresko, announced on June 19 that she would meet the creditors’ committee this week for talks on debt restructuring. She insisted that a settlement would have to involve a mixture of principal and interest rate reductions, not just the lengthened maturities proposed by the creditors.

Jaresko said Ukraine had already made an interest payment due in June to the private creditors. And on Monday, an official at Russia’s Finance Ministry said Ukraine had made an interest payment due on $3 billion in eurobonds held by the Russian government. Although it may seem odd that Kyiv is servicing that debt at a time when Moscow is supporting separatist rebels in eastern Ukraine, it did so because IMF rules prohibit a bailout for any country that has defaulted on sovereign debts to another IMF member. That is not true of debts owed to private creditors as long as the sovereign has engaged in good faith negotiations.

Ukraine’s demand for a reduction in debt owed, known as a haircut, was bolstered by a statement from IMF Managing Director Christine Lagarde, who said on June 19 that it was important for negotiations to begin so that the IMF would be able to continue to support Ukraine through its lending-into-arrears policy in the event that a negotiated agreement with creditors can’t be reached.

Andrew Wilkinson, a London-based partner of Weil, Gotshal & Manges, which represents the creditor group, tells Institutional Investor that Ukraine has an opportunity to reach a quick deal with the creditors, but he also warned the country that it could suffer the same fate as Argentina if it doesn’t agree.

“Argentina is a model to show what Ukraine should avoid,” Wilkinson writes in an email. “Argentina remains in default many years after it attempted a restructuring and is now dealing with multiple litigations as creditors attach assets and attempt to block payment systems as a direct result of the default on the non-consented bonds.”

Argentina’s plight stems from a series of court victories by NML Capital, an arm of the Paul Singer–controlled hedge fund firm Elliott Capital Management that owns bonds that were restructured by Argentina. U.S. District Judge Thomas Griesa ruled that the so-called pari passu clause in Argentina’s original bond offering, standard boilerplate used to grant equal status to different creditors, meant that the country cannot pay bondholders who agreed to the restructuring without also making the same percentage payments to NML Capital on the bonds it owns.

Griesa’s decision, upheld by an appellate court, was seen by legal scholars as a sweeping rewriting of the rules of sovereign debt default, giving new powers to holdout bondholders. Collective action clauses in new bond deals, which set the terms under which a majority of bondholders can vote to accept a restructuring, may eventually prevent future legal actions, but Richard Kozul-Wright, a director at the United Nations Conference on Trade and Development, estimates that there are $900 billion to $1 trillion in emerging market bonds outstanding with the old language that could be affected by Griesa’s ruling. Ukraine and Venezuela are just two of the nations talking about restructuring debt that they cannot afford to repay.

“We went from a world where muscular enforcement was just not a possibility to a world where muscular and disruptive enforcement is very much a reality, and that is just a very fundamental shift,” says Anna Gelpern, a law professor at Georgetown University who has written extensively on sovereign debt. “It’s the best collection device since gunboat diplomacy and certainly the most generalizable one. So I think that if you can use it, you should and you would. “

Although Ukraine’s borrowings differ from Argentina’s in some important respects — the country issued bonds under English law instead of the American law used by Argentina, for instance — there is still the possibility of a big legal fight. “I would expect either or both sides to get very aggressive or at least threaten very aggressive legal tactics,” Gelpern said.

Michael Ganske, head of emerging markets at Global Partners, a fixed income manager in London, said that although the price of credit default swaps on Ukrainian bonds declined earlier this year when it seemed as if a refinancing deal were imminent, CDS rates have widened to 3077 basis points from 2000 at the beginning of this year as fears of a default have grown.

Complicating the negotiations is the outsize role of Franklin Templeton. Michael Hasentab, manager of the Templeton Global Bond Fund, had taken a huge $7 billion bet on Ukrainian bonds and by mid-May was sitting on a paper loss of about $3 billion. Ganske says he believes Franklin Templeton is loath to write off any more debt, hardening its negotiating position.

“I think Ukraine will be a very long process,” says Guiliano Palumbo, emerging markets fund manager at investment manager Arca in Milan. “I don’t think the IMF will lend money to Ukraine to repay Russia or Russia will allow Ukraine not to repay its $3 billion debt. The longer this process lasts, the higher the level of uncertainty, the prices of the bonds will go down and the greater the likelihood that hedge funds will bottom-fish.”

Venezuela is also strapped for cash and may be thinking of rescheduling its debt, but experts say the country is much more vulnerable to outside pressure than either Argentina or Ukraine. Venezuela is an oil exporter so it has dollar assets abroad in many financial institutions that investors could go after. In addition, Citgo, an American oil refiner, is owned by the Venezuelan state oil company and would make a juicy target for hedge funds seeking to collect on debts.

Mark C. Weidemaier, an associate professor of law at the University of North Carolina, says the ramifications of the Argentine legal case could be far reaching.

“We have what is probably the most remarkable success, certainly in the last 20 or 30 years and possibly ever, at fashioning creditor-friendly law in the context of sovereign debt,” Weidemaier says. The Griesa ruling provides a blueprint for how investors can use the courts to enforce claims on defaulted sovereign debt, and “you don’t need to be as well resourced to potentially make [it] work,” he adds.

The Argentine ruling has been put to the test in only one other case, when the tiny Caribbean island of Grenada defaulted on $32 million worth of bonds and was sued by the Taiwan government-owned Export-Import Bank of China over its pari passu clause. But Grenada settled the suit before it came to trial.

Another question raised by the case is whether emerging-market countries will now forgo the U.S. as an issuing venue in order to avoid being caught up in the legal ramifications.

Rodrigo Olivares-Caminal, a professor of banking and finance law at the Center for Commercial Law Studies at Queen Mary University in London, believes that may happen. “If I am an issuer, I would think twice before going to the U.S.,” Olivares-Caminal said. “I might be more inclined to go to the U.K. rather than the U.S.”

One reason, he said, is that English courts have taken a different, more conservative view of the pari passu clauses of bond contracts than have the U.S. courts, so that they would be less likely to grant what are called ratable payments to holdouts such as hedge funds.

He noted that Greece, which issued its international bonds under English law, chose to pay off those bonds in full rather than try to restructure them and face a lawsuit in the British courts. But less than 10 percent of Greece’s bonds were in English law; the rest were issued under local law.

With English law applying to the Ukraine bonds, the government would have to win the approval of two thirds of bondholders to amend the terms of its bonds. Because Franklin Templeton owns more than 33 percent of the bonds outright, it has a blocking vote that can prevent the government from putting in place a restructuring plan.

Georgetown’s Gelpern says Ukraine’s pari passu clause seems to exempt preferences granted under Ukrainian law, which appears to leave open the possibility for Ukraine to legislate priorities and seniority unilaterally without violating the bond’s restrictions. Whether an English judge would rule differently than Judge Griesa did is a huge unknown at this point.

“The irony is that muscular enforcement and disruption do not necessarily bring about money for the creditors,” says Gelpern, who notes that NML Capital hasn’t received any money yet despite its legal victories against Argentina. •

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