Argentina lost big to a group of American “vulture” hedge funds in court last week, when the Supreme Court declined to reconsider an appeals court decision that the funds had the right to demand that the country make good on a bunch of old bonds they owned even though it long ago renegotiated the terms of that debt with most creditors. (For explanations of the case, see Felix Salmon in Foreign Affairs and Matt Levine at Bloomberg View.) Short-term, this represents a crisis for Argentina, which has until June 30 to either pay out or default. Over the long run, though, it may be a step toward removing such cases from unsympathetic American courts and letting countries like Argentina battle it out with creditors on friendlier turf.
This is an outcome that Laura Alfaro, a professor in the Business, Government, and International Economy unit at Harvard Business School and the former Minister of National Planning and Economic Policy of Costa Rica, thinks would be healthy for all parties involved. In a piece published on HBS Working Knowledge in April, Alfaro argued that the U.S. Congress took a wrong turn in 1976 in passing the Foreign Sovereign Immunities Act (FSIA), which allowed foreign governments to issue debt in accordance with U.S. law, and creditors to sue those governments in U.S. courts in the event of a default.
“One of the most damaging results of the FSIA,” Alfaro wrote, “is a false perception that foreign debt was made less risky than it is. The limited enforcement rights of investors means that sovereign debt remains risky, regardless of whether it is issued under foreign law.” It would be better, she concluded, to return to the pre-1976 practice in which each country issued sovereign debt under its own laws, a change that would “allow debtors and creditors alike to better understand and acknowledge the risk inherent in sovereign debt lending. If you lend to Argentina, you are dealing with Argentina.”
I caught up with Alfaro, who is currently in Brazil cheering on her country’s surprisingly successful soccer team, to ask a few questions by email. Here’s what she had to say:
You’ve been arguing that the sovereign debt of Argentina and other countries should in fact be treated as sovereign and thus not subject to U.S. laws. Last week’s Supreme Court decision was a pretty powerful statement that U.S. law does prevail, whatever the consequences for global debt markets. Does that pull us farther away from the outcome you want, or push us closer to it?
Alfaro: When bonds are issued under foreign law, creditors can sue a defaulting debtor in a foreign court and typically obtain a favorable judgment, since the sovereign debtor is in breach of contractual obligations. However, the value of this judgment can be limited for two reasons. First, the creditors generally cannot recover a sovereign debtor’s local assets since these are typically protected by domestic law. Second, sovereign debtors benefit from foreign governments’ sovereign immunity laws, limiting creditors’ ability to seize sovereign assets held abroad. For example, foreign assets held in a diplomatic capacity, such as military assets or an ambassador’s residence, are always protected in the United States. We still need to see if Argentina chooses to pay everyone or default. Sovereign debt continues to involve a risk. It is best if this is acknowledged explicitly by all the parties.
Does the U.S. need to amend/repeal the FSIA to get us to the sort of sovereign debt markets you’d like to see, or are there other solutions?
Perhaps the one positive effect of the ruling is that we may engage in a serious discussion of these issues (although sadly I still do not envision grand changes emerging).
Sovereign debtors can overcome collective action problems in restructurings by including ex-ante contractual provisions in the bond documentation that make it more difficult for dissenting creditors to hold out and litigate their claims, and using ex-post negotiating strategies that encourage collective action amongst creditors. The most widespread contractual mechanisms for dealing with these problems are collective action clauses that empower a qualified majority of creditors to bind dissenting creditors and thereby limit the potential threat of litigation from “holdout” creditors.
Another important issue is to change the pari passu clause, which limits the ability of debtors to privilege one group of creditors over another. Argentina’s bond offering featured the broadest version of the pari passu clause, providing for equal priority and equal payment of similarly situated creditors. In 2012, the U.S. Court of Appeals for the Second Circuit held that this prohibited it from paying one class of creditors while other creditors that are owed payment receive nothing.
In future bond offerings, sovereign debtors can avoid this interpretation by changing the wording of the clause or deleting language that provides for equal payment. They also have the option of issuing bonds under their own law. Bonds issued under local law typically limit the ability of creditors to litigate in foreign courts.
The question of why a sovereign debtor would ever choose not to insert such contractual provisions into its bond documents or issue under foreign jurisdiction remains. Sovereign debtors have an ex-ante incentive to commit to greater creditor enforcement rights in order to attract more favorable financing terms. But sovereign nations are sovereign nations. Less creditworthy countries must therefore decide whether the premium for including contractual terms that limit creditor litigation rights is worth paying.
Is there a chance that this Supreme Court decision will damage New York’s standing as a financial center?
On the one hand the decision of the Supreme Court strengthens creditor rights. On the other hand, some sovereigns may prefer alternative laws to issue their debt. As mentioned, this is a tradeoff between most favorable terms ex-ante and limitations ex-post. The important point, however, is that this is an ex-ante bargain between the sovereign debtor and the creditor and is priced into the financial terms of the transaction. Again, perhaps moving to a world where everyone explicitly acknowledges the risks would be better.
What do you think Argentina should do next?
They should start negotiating in good faith. There are attempts also to move the debt to local jurisdiction. A payment is due June 30, so we will find out what they will do. But again, showing good will matters.
With no protection in U.S. courts, would anybody outside Argentina buy Argentine debt?
History has shown that investors always come back … even to Argentina.