The Argentinian Sovereign Bond Litigation, Part II

In a previous post (The Argentinian Sovereign Bond Litigation, Part I), I roughly described the factual background for the Argentinian bond litigation, culminating in the July 30^th Argentine default of bonds.  Incidentally, Joseph Cotterill (Commentator, Financial Times’ FT Alphaville) tells us that on August 7, 2014, the Argentine Republic filed a case in the International Court of Justice in the Hague, claiming that “US court decisions . . . have violated its sovereign immunity in public international law.” That story can be found here.

In this post, I would like to focus on the particular clause which has served as the basis for the judicial decisions enjoining Argentina from paying its restructured creditors unless it also paid the holdout creditors in full. That clause is the pari passu clause – the contractual provision that promises that all (pari passu-designated) bondholders will be treated on an equal footing. A common variant of the clause reads: “The Notes will rank equally (or Pari Passu) in right of payment with all other present and future unsecured and unsubordinated External Indebtedness of the issuer.” Although the pari passu clause is ubiquitous in sovereign bonds, its meaning (or application) in the sovereign debt context is highly disputed. In fact, an empirical study, based on extensive interviews of sovereign debt lawyers, reveals at least five possible explanations, ranging from “the clause was simply the product of mindless copying from corporate bonds” to “the clause was intended to prohibit sovereigns from passing laws that would have the effect of involuntarily subordinating certain creditors.”

Why the confusion/disagreement over its meaning? In a corporate liquidation, the clause helps ensure that pari passu-ranking creditors receive equal shares of the proceeds. But in the sovereign debt context, no liquidation is possible.  Unlike private debtors, sovereigns cannot go bankrupt and their assets cannot be seized, pooled and distributed to a fixed group of claimants at a single moment of reckoning.

So what is the purpose of the pari passu clause in a sovereign bond? The federal district court in Manhattan and then the Second Circuit in NML Capital v. Argentina offered an interpretation of pari passu. They expressed the view that the pari passuclause required a debtor who was unable to pay all its creditors in full to pay each creditor proportionately or “ratably.” Hence, the sovereign debtor could not be permitted to stiff creditors who had refused to restructure their debts while paying the other creditors who had assented to the restructuring. To do so would violate the promise of equal treatment under the pari passu clause (according to these courts). And, by upholding an injunction against the third party financial intermediary responsible for transferring payments to the restructured creditors, the pari passu clause was given not only meaning but also teeth—a concrete remedy that could be used by the hold-out creditor to induce the sovereign debtor to pay its debt. These decisions disturbed many, because they threatened to make future sovereign debt restructurings more difficult—by encouraging, perhaps, more holdout strategies.

The July volume of the Capital Markets Law Journal  (CMLJ) happens to be devoted to the pari passu clause. (Links to all the CMLJ articles can be found here (subscription required), and links to the authors’ prior SSRN drafts are provided below where available.) (Apologies in advance to authors if I’ve mischaracterized some of their arguments or omitted them. I tried to be as judicious as possible.)

The centerpiece of the CMLJ volume is a fascinating work of history. Benjamin Remy Chabot (Federal Reserve Bank of Chicago) and G. Mitu Gulati (Duke) have discovered what appears to be the first use of pari passu principle in connection with a sovereign bond issue. In their article, “Santa Anna and His Black Eagle: The Origins of Pari Passu?” , they show that the spirit of the pari passu concept can be traced back to General Santa Anna’s 1843 decree promising that foreign holders of Mexican Black Eagle bonds would be treated with a “just equality among the creditors, as much as regards the rate of interest as the order of payment.” Similar language appeared in the preamble of the Black Eagle bonds, although not as a contractual provision per se. Chabot and Gulati show that the promise of equality was drafted in response to foreign outrage expressed against a former debt restructuring. This restructuring treated holders of identical claims differently based on their nationality or country of residence. Thus, the pari passu language in respect of the Black Eagle bonds appears to have been intended to prevent discrimination in payments among nationalities of the creditors in the context of a sovereign default.

Chabot and Gulati’s findings, of course, raise the question: why is the original (first) meaning of a clause relevant? Stated another way, what is the relevance of history as a guide to contract interpretation? Chabot and Gulati offer a response:

“Even if lawyers today are copying the clause by rote, surely the earliest drafters of the clause were not doing that. Someone had to have thought of this clause first. If we could find them, and figure out what they were thinking, that we potentially have a way of cutting the Gordian knot.”

W. Mark C. Weidemaier (UNC) addresses this question (“why is the original meaning of a clause relevant?”) in “Indiana Jones, Contracts Originalist”. With wit and humor, Weidemaier reminds us that, in the absence of contemporaneous evidence of the parties’ intentions, judges would ordinarily assign the clause’s historically-accepted meaning if one exists. But in a situation (such as this) where there is no historically-accepted meaning, Weidemaier asks, “ . . . why should the judge try to uncover the intentions of the first drafters?” He then answers, “Whatever the merits of originalism as an approach to constitutional interpretation, surely the originators of a contract term have only a modest claim to authority.” (But a modest claim is arguably still better than no claim, right?) Surveying the available historical evidence, including the Black Eagle bond story, Weidemaier concludes that there is no known precedent to support the Second Circuit’s interpretation that the pari passu clause grants each bondholder a unilateral right to block payments to restructured bondholders. Therefore, the million dollar question is the normative one: whether the pari passu clause, which has not traditionally served the purpose imbued it by the Second Circuit, should be repurposed to do so.

Sovereign debt guru, Lee C. Buchheit (Clearly Gottlieb), invites us to think more generally and deeply about the effort to excavate examples of contracts or clauses from a fragmentary historical record. In “A Note on Contract Paleontology,” Buchheit notes that while the Black Eagle bond story may not much clarify the substantive meaning of the modern version of the pari passu clause, it may explain “why some people have an emotional attachment to the notion of ratable payments in a distressed situation” and why modern litigants are prepared to stretch their interpretation of this boilerplate provision to assign it a meaning that neither the text nor the history of the clause can support.

My article, “Pari Passu: The Nazi Gambit” takes us through a pre-war instance of pari passu. In the paper, I present what might be the clearest historical evidence of what the clause was understood to mean in the pre-war period. I discovered this evidence while studying the protests lodged against the German government when Germany first defaulted on two international loans entered into by it during the aftermath of the First World War. When Germany, in response to its financial crisis, selectively defaulted on the American tranches of the Dawes and Young Loans, parties defending the interest of American bondholders invoked pari passu in their protests against Germany’s discriminatory practices. In claiming that Germany violated the pari passu clause, the protesters adopted the meaning that the clause promised parity in servicing across the various tranches of the Dawes and Young Loans. In other words, bondholders of the various tranches were entitled to be repaid in proportion to their holdings of debt. What’s more, based on the evidence, Germany seems to have acquiesced in this interpretation of pari passu. Perhaps more pertinent to the Argentinian bond litigation, I find no evidence to suggest that the pari passu clause was understood as entitling the aggrieved creditor to a unilateral right to block payments to bondholders who assented to a government’s restructuring proposal. In fact, neither the investors (in the Dawes and Young loans) nor the Bank for International Settlements (trustee) seemed to have interpreted the clause as a tool by which one investor could interfere with payments to another. That said, the failure to invoke an inter-creditor remedy may simply reflect the more mundane fact that legal redress of sovereign debt defaults was highly unlikely during this period.

John V. Orth (UNC) provides useful perspective in “A Gathering of Eagles.” Orth reminds us that the pari passu clause addresses a ubiquitous problem in the borrowing context: unequal payments to creditors of equal rank. Seen in this light, the story of the Mexican Black Eagle bonds is an instantiation of this ubiquitous problem. Accordingly, the meaning of the pari passu clause is clear: it promises equal treatment for all creditors of the same priority. The only problem is the application of the clause to the sovereign debt context, where it is difficult to enforce the terms against a sovereign debtor, which is the same problem with all other clauses of a sovereign bond. The implication of Orth’s piece (I think) is that the pari passu clause is not materially different from all other sovereign promises: they are all “ultimately unenforceable” and “will continue to multiply until there is an effective resolution regime for sovereign defaults.” So, in the end, Orth emphasizes the lack of a practical mechanism of resolving these types of disputes with sovereigns.

Lachlan Burn (Linklaters) is skeptical of the value of historical spelunking for interpreting the pari passu clause in sovereign debt issues governed by English law. In “History – ‘Bunk’ or a Useful Tool for Contractual Interpretation?”, Burn argues that English courts would interpret contracts in a “commercially sensible” way, which he believes “would prevent any due weight being given to the Black Eagle bonds.” After all, Burn notes, as these Mexican bonds have been sitting in a basement until their recent discovery, “[t]hey formed no part of the background information available to the sovereign issuer of bonds or the investors during the last hundred years or so.” Moreover, Burn cautions that “historical precedent will often be a dangerous tool for interpreting contracts.” Finally, Burn argues that enforcement, rather than the meaning of the pari passu clause, is the central issue underlying the Argentinian litigation. (This last point is similar to the one made by Orth.)

Tolek Petch (Slaughter and May) in “NML v. Argentina in an English Legal Setting” notes that under English law, the legal history of a clause is relevant but not determinative. Ordinarily, the court would find an interpretation that accords with business common sense as it would have been understood by both parties at the time that the bonds were issued. Therefore, English courts can and have overturned centuries of precedent on the basis that the proposed construction was not in conformity with the intentions of the parties. Petch discounts the significance of the fact that in the pre-war period Americans protestested against German discriminatory treatment because they are basically ex post facto arguments that will be seen as inherently self-serving and, more pertinently, not contemporaneous with the drafting/negotiation of the disputed provision. (Excellent point, but would Petch or English law accord any significance to the fact that Germans themselves apparently acquiesced in the Americans’ interpretation of pari passu?) Applying the “business common sense” principle of English courts, Petch in the end rejects the “rateable” interpretation of the clause, in part because “no sovereign borrower would agree to” it.  Argentina (and many sovereign debt experts) would agree with Petch’s last point!

In “Interpreting the Pari Passu Clause in Sovereign Bond Contracts: It’s All Hebrew (and Aramaic) to Me,” Mark L.J. Wright (Federal Reserve Bank of Chicago/NBER) argues that the Second Circuit “has, if not completely misinterpreted the meaning of the pari passu clause, then at least misapplied it.” He stresses the importance of interpreting the pari passu clause in the context of long-existing social norms among sovereign debt market participants. In short, it has been customary to treat holders of similar debts similarly, i.e., to repay them in proportion to their holdings of debt (measured at face value plus deferred interest). But custom also reveals a complementary “principle of differentiation,” under which certain claims (e.g., claims that had been reduced in value as a result of a prior default) were accorded preferential treatment precisely because they were meaningfully different. Applying the principle of differentiation and observing that Argentina’s restructured creditors hold bonds that have been reduced by almost 70% of their value, Wright argues that the NML decision got it all wrong and ignored the principle of differentiation.  

Side-stepping the debate over the relevance of historical origins, in “NML v. Argentina: The Borrower, the Banker, and the Lawyer – Contract Reform at a Snail’s Pace,” Leland Goss (Int’l Capital Markets Ass’n) looks to the present and the future and asks: Why have most of the foreign law governed sovereign bonds issued since the Second Circuit’s ruling failed to change their pari passu clauses? After surveying a number of explanations, e.g., network effects theory, blaming the lawyers’ risk aversion, he offers his own highly entertaining theory.

In “The injunction has landed: the ‘Black Eagle’, pari passu and sovereign debt enforcement,” Joseph Cotterill (Financial Times) recounts the Black Eagle bond history and key moments in the Argentine bond litigation to remind us that “the enforcement of sovereign debt can take many forms” and that “Pari passu is one strategy among many others,” including, e.g., discovery of assets, injunctions, and courts’ powers of equity. The Black Eagle Bond story is just as much about ad hoc enforcement of sovereign debts as it is about pari passu. And that ad hoc enforcement is what we see even today – 171 years after General Santa Anna’s decree.  

In “The origins and future of non-discrimination in sovereign bankruptcies: a comment,” Philip Wood (Allen & Overy) puts the pari passu clause into the context of the broader principle of non-discrimination and equality in payment between creditors. Wood speculates that the “concept of equality of payment by law was well established by the second century BC in Roman law.” This is evident from the laws against fraudulent conveyances, which developed around this time. Wood then provides a very helpful exposition of the byzantine devices used in sovereign debt contracts for restructurings in light of the non-discrimination principle.

In the same CMLJ volume, Jeffrey Golden (CMLJ, PRIME Fin. Found’n), Anna Gelpern (Georgetown, Petersen Inst. for Int’l Econ.), and Joanna Benjamin (London School of Econ.) also have very interesting contributions (but not on the topic of the pari passu clause).

What’s the long-term impact of the judicial rulings? Anna Gelpern (Georgetown, Petersen Inst. for Int’l Econ.) has some interesting thoughts in her “Sovereign Damage Control.”

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