Last month, after the U.S. Court of Appeals for the Second Circuit heard marathon arguments to mull Argentina’s obligations to dueling groups of bondholders, I posed the question, "Will the Second Circuit Act as a Sovereign Bankruptcy Court?" In this column I will briefly guess the answer. Then I will consider where the appellate court went wrong, and what it ought to do.
Back in October the Second Circuit read the pari passu clause in Argentina’s sovereign bonds to require that the republic give equal treatment to investors that agreed to trade in their bonds for about 35 cents on the dollar, and those who refused to participate in the restructuring deal. When the Second Circuit heard oral arguments on Feb. 27, Argentina invited the panel to play the role of a sovereign bankruptcy court, and to rewrite the original bond contract on an equitable basis. Otherwise, the Republic’s lawyers insisted, Argentina will default on its restructured bonds.
Is the Second Circuit willing to play this role, and how?
The appellate panel tipped its intentions in a March 1 order asking Argentina to make a payment proposal, as two leading commentators have already noted. (See here and here.) In asking Argentina to clarify how it proposes "to make current those debt obligations on the original bonds that have gone unpaid over the last 11 years," the Second Circuit signaled that it is determined to give the holdout creditors treatment that Argentina is equally determined not to give. Argentina wishes to give the holdout creditors the same haircut it gave to its restructured creditors, while the Second Circuit is looking to enforce as much of the original bond contract as it can. On that basis, it’s nearly impossible to imagine a compromise acceptable to both Argentina and the judges.
Even if the Second Circuit thinks it would be equitable to give all creditors the same haircut (and clearly it does not), it’s in no position to do so. How can the Second Circuit give Argentina what it wants, under an ultimatum from the country’s leaders, when it set out to give the holdout creditors what they want? That would be no way to run a court that commands the respect of the world.
So here’s where we are: The Second Circuit torpedoed the system of sovereign restructuring in its pari passu ruling; it was invited to play sovereign bankruptcy court, but the only remedial order that can avert a second default would undermine the court’s authority; and anyhow, it has already signaled that it does not regard such an order as equitable.
The Second Circuit has only its own rigidity to blame for this impasse. My lasting impression of the February hearing is of Judge Reena Raggi’s face appearing oversized on the screen of the second overflow room, her brows knit and her eyes flashing with righteous moral fury. Righteous moral fury has no place in a contract dispute among a sovereign and two sets of savvy investors who understand the rules of the game.
The players in this game understand that in what passes for our sovereign restructuring system, Argentina’s role is to respect one set of contracts and disrespect the other. In the absence of a sovereign bankruptcy court, restructuring is the only way for a state in crisis to avoid inflicting either a depression on its people or total losses on its creditors. That means paying some creditors what the market will bear, and stiffing the rest in the expectation that the sovereign will be chased through the world’s tribunals on all manner of legal theories. A partial legal victory for one side may raise or lower the price of restructuring in the future, but will not fundamentally alter the game.
In this game, the players’ moves are morally neutral. The outcome of the game is socially desirable (even if it is less efficient than a proper system of sovereign bankruptcy). Both the holdouts’ effort to enforce their contract rights and the sovereign’s disrespect of contract rights redound to the public good–by keeping equilibrium in a system that lets states restructure without halting global investment flows. That’s true whether the holdout is a mom-and-pop investor or a hedge fund, and it’s true whether the state is highly-impoverished or middle income.
The likelihood that some hedge funds have used derivatives to bet that Argentina will default as a result of their victory makes the mind spin. But while the complexity of these arrangements is a good argument for sovereign bankruptcy, as well as for the regulation of derivatives, I still don’t see a moral dimension. Much as I love the vividness of the terms "vulture" (for the holdout creditors) and "deadbeat" (for Argentina), they obscure more than they reveal.
The problem arose when the Second Circuit took it upon itself to grant the holdouts total victory, on an entirely-unnecessary literal reading of bond contract boilerplate, which is impossible to square with the system’s design or the understanding of market participants. Suddenly the game is no longer tenable. To be sure, market players may work around the New York pari passu ruling in the future–by altering the equal footing clause or issuing bonds under English law, or both. But a nation in economic crisis that has already issued bonds under New York law may be unable to restructure its debts. In the near term, a $24 billion restructuring will unravel.
This is not a situation where a standing body like the U.S. Congress may easily undo the real-world harm wrought by a tone-deaf court ruling. By all accounts, the nations of the world lack the political will to create a system of sovereign restructuring, which would be the ideal solution.
The realistic solution is for the Second Circuit en banc–or the U.S. Supreme Court–to accept the entreaties of the U.S. government and the commercial banking industry to revisit the pari passu ruling of Oct. 26. A court reading an indeterminate clause in a sovereign contract should absolutely take into account the consequences of its interpretation. That ruling’s damage looks harder to fix than the damage from the hurricane that struck the same week.
Of related interest:
