Question: when is a sovereign not a sovereign? Answer: when the rights in question are attached to Argentinian government debt – or at least, that is the worrying implication of a recent court ruling.
The consequences of the New York court decision raises not just the prospect of an imminent Argentinian default but also deeply worrying questions about both the future tenability of sovereign restructures and the rights of governments under sovereign immunity.
The New York appeals court decision – a major victory for leading vulture fund Elliott International – ruled that Argentina could not continue paying dividends to owners of restructured New York law bonds without also paying out to investors who never signed the 2005 and 2010 debt exchanges.
While referring back the fine detail to a district court for a decision, the New York appeals court ruled that any intermediary who paid out to debtholders – primarily the Bank of New York, trustee for the dividend payments – would be liable to charges of aiding and abetting a crime.
‘If you extrapolate from this, then you would have to say you are offering a big disincentive to people to tender into any future debt exchange [following default],’ says Citywire AA-rated Colm McDonagh, manager of the Absolute Insight Emerging Market Debt fund.
With the world facing an overhang of previously high-rated sovereign debt at a real danger of never being paid back, the implications of the ruling have a lot of people very worried.
‘I bet the “risk factors” sections of sovereign prospectuses are getting a close read just now,’ said sovereign debt legal specialist Professor Anna Gelpern of the Washington College of Law.
McDonagh admits he has reread some of the contractual wording on debt in his portfolio but says until there is further legal clarification, there is little managers can do beyond taking each debt issue on its own merits.
Argentinian debt responded dramatically to the ruling, with the spread of credit default swaps rising by 585 basis points and yields on all classes of paper spiking, but so far there has been little read-across to other countries.
Uruguay, which conducted a debt default and restructuring in parallel with Argentina but has remained on much better terms with its creditors, has yet to be affected by the decision.
Setting a precedent
Capital Economics’ emerging markets economist Michael Henderson says the breakdown in relations between Argentina and its creditors was likely to have been a part of the court’s decision.
The government has gone as far as legislating rules illegalising any payment to holdouts by any future administration, known as the Lock Law, and has elsewhere been described as intransigent.
‘[President] Cristina Fernández’s second term has been marked by erratic, market-unfriendly policies and the relationship with the holdouts has been a long and bitter one,’ says Henderson.
McDonagh, who has a small holding in Argentinian law debt, says there is likely to be an extended period of price discovery, hampered by low liquidity, before the market finds a new risk premium. He says the government is solvent and needs access to capital markets, however.
With Argentina making up little more than 2.5% of global sovereign indices, and many managers having already given up on its paper on volatility grounds, the greater concern remains the legal precedent.
Legal opinion remains split. Some argue that collective action clauses (CACs), which have been commonly adopted in the past 10 years, will prevent holdouts from exercising such power on more recent debt, while others say CACs are little more than a legal boilerplate, and full of loopholes.
‘It looks like previously unenforceable sovereign debt has suddenly become more enforceable,’ says Gelpern. ‘Zero to something. But how much? It depends on too many things to know for sure.
‘Will foreign courts adopt the Second Circuit’s reading, exposing countries such as Italy to Argentina-scale uncertainty? For what it’s worth, this is where I feel most comfortable being worried. I will be looking for more data on just how many other countries have vulnerable formulations of the [creditor equality] clause.’