Sovereign Debt and the “Trial of the Century”

The sovereign debt dispute involving Argentine bonds has attracted substantial attention and raised a number of novel and significant legal issues. This short essay provides a brief overview of this controversy.

In 2001, the Republic of Argentina experienced a severe economic crisis. Inflation rose to over 40%, the stock market lost 60% of its value, and nearly half of the population was living below the poverty line. In response, Argentina declared a temporary moratorium on payments on more than $100 billon of public external debt. In 2005 and 2010, the government offered to exchange the defaulted bonds for new debt instruments, worth approximately 30% of the original bonds. Most bondholders accepted the new terms, and these agreements covered 92.4% of the debt.

Several hedge funds that had purchased Argentine bonds on secondary markets refused to exchange their defaulted bonds for new securities. Instead, they filed lawsuits to collect the debt in full, plus interest. By 2014, these firms obtained final judgments in a U.S. court totaling nearly $2.4 billion.

In some of these actions, the court relied on “pari passu” clauses in the bonds, providing that the obligations in the original bonds would rank equally with Argentina’s other foreign debt obligations, to preclude Argentina from paying the exchange bondholders unless it also paid the hedge funds in full, and entered an injunction to this effect. The broad injunction covered not only Argentina, but also third parties, such as banks who act as intermediaries in making payments on Argentinian obligations. In June 2014, the U.S. Supreme Court denied Argentina’s petition for certiorari.

Payments to exchange bondholders were due June 30, 2014. In late June, Argentina deposited over $500 million, the amount of interest it owed to those bondholders who had agreed to new terms, with Bank of New York Mellon (BNY), the bondholders’ indenture trustee. However, Argentina refused to make payment to the hedge funds, because they had not agreed to new terms. As BNY was subject to the court’s injunction, it did not distribute payments to the exchange bondholders, and Argentina was declared to be in default.

In fall 2014, Argentina sought to replace BNY as the trustee with a state-owned bank in Argentina. The federal district court judge declared that this effort was “illegal and cannot be carried out,” and found Argentina to be in contempt of court. Argentina’s foreign minister denounced the contempt order as a “violation of international law.” In August 2014, Argentina filed suit against the United States at the International Court of Justice; however the case will only proceed if the United States consents to jurisdiction – a highly unlikely development.

When private firms default, domestic bankruptcy procedures typically provide for an orderly resolution among creditors and the debtor. By contrast, no formal bankruptcy system exists for sovereigns.

Among other issues, the Argentina sovereign debt dispute raises questions about whether the informal system that has developed – in which states attempt to restructure their debt with creditors, typically integrating debt relief with new financing and economic policy adjustment – is still viable, or whether a new, multilateral mechanism is needed. Given the trillions of dollars directly or indirectly affected by the integrity of sovereign debt and the ability to restructure that debt, Argentina’s case could truly prove to be the case of the century.

1 thought on “Sovereign Debt and the “Trial of the Century””

  1. “Full faith and credit” lies at the core of this. A Sovereign issuing debt asks (and expects) purchasers to rely on its promise to pay. That there is no bankruptcy-type mechanism to allow a later restructuring is the risk the sovereign assumes. Were lenders to understand the circumstances to be otherwise, the capital markets will no longer invest in such debt. Or at least investors’ appetites will greatly diminish, especially where the lender has a poor track record of mismanaging its economy. Consider the present situation in Greece!

    Argentina’s actions in reissuing replacement bonds is essentially a contractual arrangement for the benefit of creditors and was largely, but not entirely, accepted by the holders of it (92.4% to be exact). It was the right of the hedge funds to rely on Argentina’s original promise. Not liking the score, the sovereign can’t change the rules in the middle of the game. This is the fundamental market truth grasped by Alexander Hamilton over two centuries ago. Like Newton’s Apple, it is a fundamental economic principle of nature; failing to hold sovereigns to the obligations of their bargains will visit havoc on the capital markets.

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