Can Argentina Save Itself from Its Debt Dilemma?

Time is running out for Argentina — and for the hedge funds suing it, led by Elliott Management Corp.’s NML Capital. The South American nation must submit a proposal to the U.S. Court of Appeals for the Second Circuit before the end of March on how it plans to repay an estimated $1.33 billion of defaulted bonds.

Besides Elliott Management of New York, bondholders in the suit against Argentina include funds managed by Aurelius Capital Management, also of New York, and a smattering of individuals.

Although it is not unprecedented for hedge funds to sue a nation that has defaulted on its debt — indeed, Elliott Management has done so successfully on more than one occasion — Argentina’s refusal to agree to a settlement sets it apart. The country’s president, Cristina Fernández de Kirchner, has vowed never to pay what she calls vulture funds.

The case raises important questions about whether U.S. courts can compel another country to honor its bond obligations. The conventional wisdom is that sovereigns repay their debt not because they fear litigation but because they wish to preserve their standing in the international markets or because they have some other incentive to do so, according to W. Mark Weidemaier, assistant law professor at the University of North Carolina at Chapel Hill. “The ongoing case of NML Capital versus Argentina has the potential to shatter this consensus,” Weidemaier says.

As recently as last week, Paul Singer’s Elliott Management tried, after numerous failed attempts, to broach settlement talks with Argentina, but the firm was rebuffed, says a source familiar with the situation. Argentina’s response, the source says, came from the top echelons of government: “They basically said, ‘Sorry, but we’re going to win.’”

Many of those who attended a Second Circuit hearing in Manhattan on February 27 believed differently. No sooner had lawyers for Argentina concluded their arguments than murmurs arose in the crowded gallery that the three-judge panel, comprising justices Reena Raggi, Rosemary Pooler and Barrington Parker, was not buying Argentina’s reasons for withholding the payments. Indeed, the judges openly criticized the country’s stance that it would rather default on its sovereign debt than pay the litigants.

This month brought an unexpected twist. Soon after the hearing, the judges reopened discussions with Argentina, asking it to explain how, exactly, it planned to repay the funds and the other bondholders, who so far have received nothing. By doing so, the judges appeared to be allowing Argentina one last chance to propose a resolution to its debt bind before the court hands down a ruling.

Holders of more than 91 percent of Argentina’s bonds agreed in 2005 and 2010 to exchange their original bonds for restructured ones or risk not being paid at all. They now receive a steeply reduced payment. The minority holdouts did not agree to the terms of the exchange and are still waiting to be paid.

The judges’ order, issued March 1, noted that during the February 27 hearing Argentina hinted it was “prepared to abide by a different formula for repaying debt owed on both the original and exchange bonds at issue in this litigation.” The panel asked Argentina to specify “the precise terms” of “any alternative payment formula” by March 29, as “neither the parameters of Argentina’s proposal nor its commitment to abide by it is clear from the record.”

That’s a shift from the court’s earlier position, presumably intended to test the lines drawn by Argentina. In February the same court stated it would uphold the bonds’ pari passu clause — a Latin phrase meaning “with an equal step” — that legally compels Argentina to pay all its bondholders, not just the exchange bondholders who agreed to reduced payments.

The March 1 order evidently threw everyone for a loop. “This case has been full of surprises,” says Anna Gelpern, a professor at American University Washington College of Law who specializes in international finance. “Every single dominant prediction has been wrong. Every single consensus view has not turned out to be correct. It is almost humorous, actually.”

Gelpern, who has been following the case closely, is hard-pressed to glean what the order means. “The court is probably trying to offer Argentina a chance to put something forth,” she says, “but whatever Argentina proposes, I don’t think it will be good enough.”

Adds one executive at a New York–based distressed-asset hedge fund firm betting on the outcome of the case, “We don’t see this order as a chance for Argentina to save itself; we see it as the court giving Argentina some rope to hang itself with.”

To be sure, the stakes are high for the hedge funds, which face losing a big bet that’s lasted more than a decade, and for Argentina, which has tried hard to regain its standing in global financial markets since its 2001 debt default.

“Argentina is the world’s leading exemplar of how a sovereign should not treat its creditors,” asserts Mark Brodsky, CEO of $3.4 billion Aurelius Capital. “The global financial system is placed at risk by rewarding such behavior.”

Exchange bondholders especially have opposed the lawsuit by the hedge funds because it means they may find their own payments drying up. Some have even suggested that a win by the funds could impede future sovereign debt restructurings and significantly undermine global finance.

Brodsky finds these arguments disingenuous. “Our adversaries resort to fear-­mongering,” he explains. “They keep repeating the unsubstantiated claim that sovereign debt restructurings will screech to a halt if [the court’s decision] is upheld.”

All previous evidence, including the recent restructurings in Greece and Belize, contradicts this, Brodsky says. “The circumstances presented in the Argentina case are so unusual, they would be virtually impossible to replicate,” he adds.

In the 1990s, Peru went through a similarly protracted battle with Elliott Management but ultimately settled with the hedge fund manager. Elliott Management declined to comment for this story, as did attorneys representing Argentina.

All hinges on the Second Circuit’s interpretation of the pari passu clause, which maintains that Argentina must honor the exact terms of the original bonds owned by Elliott, Aurelius and other holdouts just as it does the exact terms of the exchange bondholders’ arrangements.

“Argentina may choose, consistent with the equal-payment treatment, to treat everybody equally by paying no one,” says Stephen Marzen, a partner at New York law firm Shearman & Sterling who specializes in international civil litigation and appeals. “It is New York’s interpretation of the pari passu clause that is driving everything. It’s the linchpin of this case.”

The pari passu clause, which has been buried in the fine print of bond deals for more than a century, has long been seen as antiquated and incidental. Not so in this case, where pari passu handcuffs the fate of one to all, creating a situation in which a court’s decision will set into motion a chain of events that could leave Argentina in default and all the bondholders at a loss.

Though Argentina has said it is prepared to take the case all the way to the U.S. Supreme Court, the final stop after the Second Circuit, Marzen, who has argued six cases before the high court, does not think the Supreme Court will take the case. “Even though it is the main event, the pari passu provision is a question of New York State law, not federal law,” says Marzen, whose firm is not involved in the case. “The Supreme Court generally resolves conflicts among the lower courts about federal law.”

The federal question Argentina may try to bring to the Supreme Court, Marzen notes, is whether the court order to treat all bondholders the same constitutes a violation of Argentina’s rights under the Foreign Sovereign Immunities Act. “The problem is that the one section of the act they might try to use only prevents the taking of a foreign sovereign’s property,” explains Marzen. “The order for equal treatment of bondholders doesn’t take any property. Instead, it puts a condition on Argentina’s use of its property — the condition being not to pay one set of bondholders over another. It’s going to be pretty challenging to equate a condition with a taking.”

The options of the hedge funds are no less costly. “If Argentina decides not to pay them, the hedge funds would be left to pursue assets within the existing judgments, and so far they have not had much relief there,” says Marzen. “Argentina is very well advised and has managed to mostly avoid asset seizure for the better part of 11 years. It does not leave assets around to be snatched.” (That is, with the noteworthy exception of one Argentinean ship briefly seized last year in Ghana.)

Still, Argentina’s plea last month to the Second Circuit to be allowed to continue payments to the exchange bondholders suggests that the Kirchner government believes nonpayment would come at a price. “For the past several years, Argentina has worked hard to keep current on payments to the exchange bondholders and has been on the path to becoming an honorable citizen,” Marzen says. “Like Johnny Cash, they’ve been walking the line, and if they default on these bonds after paying them for years, I don’t think they’re going to be too happy about it.”

With Argentina already in default on the bond payments it still owes the hedge funds, further default on the exchange bonds likely wouldn’t send shock waves through the global financial system, traders say. “The fallout will hurt Argentina and roil the markets that are linked with it, but it will be contained, not systemic,” one London-based trader says.

Another default by Argentina would probably result from a U.S. court order rather than an inability to pay. Nonetheless, that fact wouldn’t win the country any lenience from credit agencies, says Sebastian Briozzo, Standard & Poor’s Buenos Aires director of sovereign ratings for Latin America.

“Whether it is a technical default does not matter,” says Briozzo. “If they don’t pay, it is no longer a matter of opinion; it is a matter of fact. We rate the country based on whether they pay in accordance with the bonds’ agreed-upon terms and conditions.” S&P rates Argentina at B–, or junk, with a negative outlook.

Because Argentina hasn’t attempted to issue bonds since 2001, a default likely wouldn’t change the status quo in terms of the country’s ability to tap capital markets, adds Briozzo.

Instead, Argentina would need to be more concerned about its standing with global lenders such as the Inter-American Development Bank and the World Bank. “If Argentina were to default on its debt again, this could hurt its borrowings and disbursements,” Briozzo says.

For Elliott Management, which has remained tight-lipped about how it would deal with an Argentinean default, the end game is even murkier. “Elliott is not going to take this lying down,” American University’s Gelpern predicts. “These funds have a lot at stake, including their business models. They can’t be seen settling for pennies after almost 12 years of waiting.”

For the moment, observers can’t help but think that the hedge fund firm, which has made a name for itself by investing in the bonds of financially strapped sovereign nations and then suing them for failing to make payments, has finally met its match. As David Tawil, co-founder of Maglan Capital, a distressed-asset fund in New York, puts it, “You have to love the fact they have met their ultimate opponent in Argentina, an opponent that is as willing to fight and as stubborn as they are.”