As participants in an increasingly global economy, U.S. corporations and investors are increasingly identifying opportunities to invest in foreign debt securities, including debt securities issued by foreign governments. But such investments come with an added layer of risk: When a sovereign nation defaults, investors in its debt securities are often left without recourse. Unlike an ordinary corporate debtor, a sovereign cannot be forced into a bankruptcy proceeding to determine the order in which creditors will be paid. Rather, the sovereign itself can decide which debtholders to pay (if any). Adding insult to injury, the sovereign may seek to restructure its debt to meet its needs, issuing new debt in exchange for the defaulted debt on terms far less generous than those originally agreed to by the debtholder.
However, recent litigation in the case NML Capital, Ltd. v. Republic of Argentina suggests that U.S. courts are increasingly utilizing the tools at the judiciary’s disposal to protect the rights of U.S. investors in foreign sovereign debt. The case arises out of Argentina’s sale of dollar-denominated bonds (the FAA Bonds) in 1994. Following years of economic turmoil, Argentina defaulted on the FAA Bonds in 2001 and ceased making principal and interest payments. Argentina subsequently offered to exchange the FAA Bonds for new “Exchange Bonds.” However, Argentina’s exchange offer came at a price: Holders of the FAA Bonds who elected to participate in the exchange offer would receive Exchange Bonds with a face value of approximately twenty-five cents for each dollar of FAA Bonds exchanged. Despite that huge haircut, 91 percent of the holders of the FAA Bonds ultimately tendered them in exchange for the Exchange Bonds.
Following the issuance of the Exchange Bonds, Argentina made regular payments to the holders of Exchange Bonds, while refusing to make payments on the remaining outstanding FAA Bonds. Indeed, Argentina went further: It enacted legislation forbidding its officials from paying on the FAA Bonds and prohibiting its courts from recognizing judgments on them.
In 2003, non-tendering holders of the FAA Bonds brought suit in federal court in the Southern District of New York. The plaintiffs — largely hedge funds and other institutional investors — subsequently amended their complaints to allege that Argentina’s failure to make payments on the FAA Bonds while paying on the Exchange Bonds violated the FAA Bonds’ pari passu clause. That clause provided that Argentina’s obligations to make payments on the FAA Bonds “shall at all times rank at least equally with all its other present and future unsecured and unsubordinated [foreign debt].”
The district court agreed with plaintiffs and issued a series of injunctions against Argentina and its agents. It ordered specific performance, requiring Argentina to pay holders of the FAA Bonds on the same terms and same dates on which it paid holders of the Exchange Bonds. It also forbade Argentina from “altering or amending the processes or specific transfer mechanisms by which it makes payments on the Exchange Bonds” without the court’s approval.
Argentina promptly appealed to the United States Court of Appeals for the 2nd Circuit. On appeal, Argentina principally argued that the pari passu provision merely protected against legal subordination via the creation of legal priorities by the sovereign in favor of creditors holding certain classes of debt, not the mere refusal to pay. The 2nd Circuit disagreed, and in August 2012 affirmed the district court’s decision. In doing so, the court found that the clause was intended to protect the holders from more than just formal legal subordination. Instead, the court concluded, the pari passu clause prohibited Argentina from paying on other bonds without paying on the FAA Bonds. The court grounded its conclusion in logic, noting that a contrary result would permit the defaulting sovereign to choose for itself the order in which creditors would be paid. The 2nd Circuit also upheld the district court’s grant of an injunction, noting that the injunction did not attach Argentina’s property (an act that could run afoul of the Foreign Sovereign Immunities Act), but merely directed Argentina to comply with its obligations. Argentina subsequently sought review from the U.S. Supreme Court, but in October 2013 the Court declined (without comment) to hear the case.
As a result of this litigation, the plaintiffs will be able to pressure Argentina to pay on the FAA Bonds or face default on all of its outstanding sovereign debt. However, one consideration should mitigate bondholders’ elation. In reaching its decision, the 2nd Circuit noted the prevalence of collective action clauses, which allow the issuer to amend the terms of its bond issuances provided a supermajority of the holders consent. Had such a clause existed in the governing document for the bonds at issue, Argentina could perhaps have persuaded a supermajority of the holders to agree to waive the default and extend the payment terms. Buyers of foreign debt, therefore, must be prepared to band together to prevent such supermajority approval, or else face the prospect that the terms of the bonds will be changed without their consent.
While not perfect, the courts’ holdings in NML Capital, Ltd. v. Republic of Argentina should offer some reassurance to U.S. investors in foreign sovereign debt. Investors can feel more confident that, in the event they are treated unfairly by the foreign issuer, they can seek effective recourse in the U.S. courts. In the increasingly global marketplace, it is comforting for corporations and investors — and their counsel — to know that when entities invest abroad, their rights will be protected at home.