It seems that a sovereign nation defaulting on its debt is now just a matter of when not if. As the Greek debt crisis rumbles on, the Iceland external position is still delicate and with Argentina expected to make a new offer to its creditors imminently vulture funds and some hedge funds might be licking their lips at the opportunities such events throw up.

When a sovereign nation defaults it restructures its outstanding debt by means of an exchange offer under which creditors agree to receive a new debt instrument in exchange for the old (non-performing) one which usually implies worse financial terms. The process of drafting the proposed exchange offer comprises the views and interests of the debtor and to a certain extent those of the creditors since their participation is required. However, it is impossible to accommodate the interests of all creditors since they will have different views. Once an exchange offer has been settled the defaulting nation will commence payout of the new bonds under the restructured deal.

However, there will often be a proportion of creditors who will be holdouts on the exchange offer and who will seek a better deal than that put forward by the sovereign nation. Holdouts will usually be specialists in distressed debt – vulture funds. In the last 20 years there have been a number of high profile cases where vulture funds have been holdout to a sovereign debt restructuring. In many cases they have generated excellent returns. This article will look at an example of how a vulture fund used the holdout strategy to generate profits of 400% on distressed Peruvian debt. But the effectiveness of the holdout strategy has been thrown into question by a more recent case. As new opportunities for vulture funds proliferate thanks to the international economic crisis will vulture funds continue to be able to generate such dramatic returns?

Elliott Associates
In the Elliott case (Elliott Associates L.P. vs. Republic of Peru and Banco de la Nación del Peru), Peru found itself in the New York courts facing a claim from Elliott Associates. Elliott Associates is a vulture fund that in 1996 had purchased defaulted loans in the secondary market at a steep discount. Elliott Associates purchased loans of a face value of US$20.7 million and paid US$11.4 million.

In 1998 Elliott Associates won a decision in the New York Court of Appeals allowing it to enforce its credit against Peru. The Court of Appeals balanced two aspects: first, granting the possibility to US citizen creditors to claim the payment of their monies, which limited the chances of achieving debt restructuring under the IMF’s umbrella; and secondly, not allowing the claim because it would prejudice New York as a financial centre. Both issues were important for US foreign affairs policy. The Court of Appeals concluded that the protection of investors should take priority.

Elliott Associates’ strategy was to win attachment orders, which would allow it to claim its credit on payments made by Peru to other creditors who had accepted its exchange offer. The renegotiated debt under the exchange offer were loans that were swapped for Brady Bonds (the bonds issued to replace the outstanding debt). Peru would be stopped from paying interest on the Brady Bonds to bond-holders who had accepted its exchange offer until it had settled Elliott Associates’ claim. Elliott Associates’ strategy was twofold: (1) trying to attach the funds at the level of the fiscal agent to prevent payment to other debt-holders; and, (2) capturing funds at the level of the clearing houses.

Attachment orders were obtained by Elliott Associates in different US states (Florida, Maryland, New York and Washington DC) which hampered the payments to be made by Peru’s fiscal agent on the Brady Bonds. In response Peru arranged the creation of a trust to perform twice a year the payment of the interests due on the Brady Bonds on its behalf. The peculiarity of this case was that the lack of assets to attach in the US forced Elliott Associates to resort to the Courts of Belgium, Canada, England, Germany, Luxemburg and the Netherlands to seek enforcement of the decision it had won in the New York Court of Appeals.

On 26 September 2000, Elliott Associates obtained a restraining order from Brussels’ Court of Appeals prohibiting Chase Manhattan, Peru’s financial agent, and Euroclear, its clearing house, from paying interest on Peru’s Brady Plan bonds (approximately US$80 million was due on 6 October 2000). The Court of Appeals resolution stated that ‘[i]t … appears from the basic agreement that governs the repayment of the foreign debt of Peru that the various creditors benefit from a pari passu clause that in effect provides that the debt must be repaid pro rata among all creditors’.

With the judicial order preventing payment, Peru was facing default on the recently issued Brady Bonds totalling US$3.837 billion. Peru had been prevented by Elliott Associates from making payments through its fiscal agent (because of the attachment orders in different states in the US) or through Euroclear (because of the Brussels judgment). Only one avenue for payment remained open to Peru, and that was to make the interest payments on the Brady Bonds through Clearstream, another clearing house.

Making the interest payments through Clearstream would have implied that only those bondholders holding an account with Clearstream would be paid or that bondholders not holding an account with Clearstream should open an account there (which implied an additional cost to Peru). In addition, it was only a matter of time until Elliott Associates would obtain a restraining order in Luxembourg on funds paid through Clearstream. This scenario obliged Peru to reach an agreement with Elliott Associates in order to avoid a new default in its restructured debt under the Brady Plan. On 28 September 2000, Peru enacted a Decree to negotiate and settle Elliott Associates claim.

The total debt calculated as of 30 September 2000 totalled US$57.5 million. Added to thissum was US$9 million in legal expenses. The final settlement agreement entailed a payment totalling US$58.45 million. The settlement agreement was executed on 29 September 2000 and Peru was able to pay the due interests in time thereby avoiding incurring a new default. It also meant that Elliott Associates obtained a profit of 400% on its purchase cost of the defaulted bonds. The decision of the Belgium Court of Appeals was grounded on the violation of equal treatment of creditors under the pari passu clause.

In the Elliott Associates case their holdout strategy achieved huge returns but this approach has been thrown into doubt by a more recent case. In Elliott Associates, the holdout strategy worked because the pari passu clause meant that no creditor was to be given preferential treatment, regardless of whether they had accepted the exchange offer or whether they were holdouts. A more recent case has left question marks over whether vulture funds will be able to rely on the pari passu clause in the future.

LNC LLP. vs. Nicaragua
During 2003, as in the Elliott Associates case, the vulture fund LNC LLP. obtained a favourable ruling before New York courts ordering Nicaragua to pay US$87 million. The main object of the claim was certain commercial loans which the Government of Nicaragua defaulted on during the eighties. These loans were restructured by the Government of Nicaragua but LNC LLP. decided to holdout and file a suit.
LNC LLP. appeared before Brussels’ courts to enforce the judgment they had won in New York. Like the Elliott Associates fund, LNC LLP. obtained an order from Brussels’ courts that prohibited payment of interest on the so-called ‘indemnity bonds’ issued under the referred restructuring. The payment prohibition fell on the fiscal agent (Deutsche Bank AG) and Euroclear. But this ruling was appealed and the Brussels Appellate Court decided to reverse the trial court’s judgment. It might seem that the ruling reversed the criterion of the Elliot Associates case and undermines the ability of holdouts to force sovereign nations to settle their claim, but it would be premature to be carried away by such a conclusion. The Appellate Court did not consider the important issue of the pari passu clause, as was done in the Elliott Associates case.

The financial world has assigned a level of importance to the Belgian court’s decisions that they probably do not merit because the rulings are on issues governed by the laws of the State of New York. The New York courts rather than the Belgian courts are the real experts on their law as well as on US federal law and US foreign and international debt policy.

In 2003, under the framework of the Argentine debt restructuring, a judge of the State of New York for the first time had the opportunity to pass judgment on the scope of the pari passu clause, which would have provided much clarity on this area. In the event, the District Judge resolved the issue at stake based on a procedural issue and avoided interpreting the pari passu clause under US law. The jurisprudential interpretation of the scope of this clause is still therefore an open issue. The international market for distressed debt will keenly await clarification of the US approach to pari passu clauses.

However, it should be pointed out that a Belgium law (4765 [C-2004/03482]), became effective in December 2004 which protects the flow of funds made through Euroclear from the attachments or liens from creditors. This could make it much harder for vulture funds to prevent payout under an exchange offer and thereby force a sovereign nation to settle their claim. This notwithstanding, creditors might be able to resort to other jurisdictions or strategies in order to force a settlement. A clear example is the attachment that was levied on the Argentine bonds by those creditors who rejected the debt exchange offer, which resulted in a delay in the settlement of the bonds. Technically speaking, the attachment was not levied on the bonds, as theRepublic of Argentina was not owner of the bonds until settlement under the exchange is made. The attachment was levied on Argentina’s future right to receive such bonds, which was originally scheduled for 1 April 2005 and was postponed until the attachment was finally released.

The confusion generated by the Belgian courts and lawmakers means that if a sovereign nation defaults as a result of the current world financial crisis, vulture funds and other holdouts will be less certain about their strategy. Vulture funds play a vital role in providing liquidity and a floor for the value of the debts of many poorly graded borrower countries. They can also generate excellent return for investors. Exactly what legal tactics vulture funds can use is in doubt. However, what seems certain is this financial crisis and the burden it has placed on sovereign borrowers will spur vulture funds on to find a whole new array of legal tactics and strategies.

Dr Rodgrigo Olivares-Criminal is the author of Legal Aspects of Sovereign Debt Restructuring, published by Sweet & Maxwell