June 9, 2015 Samuel George

The Rise of the Holdouts: Disrupting Sovereign Debt Restructuring

In the wake of the 2001 Argentine financial crisis and subsequent default, firms specializing in distressed sovereign debt purchased defaulted Argentine bonds at steep discounts with the explicit intent of subsequently litigating for payment of full face value plus interest.

These firms have achieved international notoriety stemming from their recent legal victories against the government of Argentina, but the strategy of investing in distressed bonds and resisting restructuring is by no means original. In fact, holdout funds have been developing, improving and employing different strategies for roughly three decades.

Two developments in international sovereign debt created an opening for holdout firms. First, in the years following World War II, the US adopted a more limited interpretation of sovereign immunity. Sovereign immunity previously offered near complete legal protection for international governments. But with the rise of state owned enterprises acting internationally—specifically those of the Soviet Union—such an interpretation seemed inappropriate for states engaging in commercial activity, and the US drifted away from it in the 1950s.

The updated interpretation, codified in the Foreign Sovereign Immunities Act (FSIA) of 1976, would not cover commercial enterprise, thus paving the way for litigation in US courts for international sovereign bonds issued in New York.

Secondly, the advent of Brady Bonds following the Latin American debt crises of the 1980s demonstrated the market appetite for risky and/or distressed emerging-market debt. Brady Bonds converted relatively-illiquid sovereign bank debt to fungible bonds openly traded by investors. Cognizant of a new opportunity, emerging markets increasingly issued debt directly to investors in bond form (rather than relying on bank debt), creating a massive investor market for developing-world debt.

Together, these trends offered risk-taking firms the opportunity to collect distressed debt cheaply on the second hand market, and take the notes to court to demand payments worth full face value.

Before Argentina: Brazil, Panama and Peru

As holdout firms gained experience, they developed more effective tools to interrupt debt restructuring. In the early 1990s, Dart Management—a holdout firm currently in litigation with Argentina—accumulated US$1.4 billion of 1980s-era distressed Brazilian debt, and sued the Brazilian Central Bank in New York demanding full face value. The courts ruled at least partially in in their favor, and “the Darts came out much better than creditors that had accepted the Brady exchange.”

Over the following years, increasingly specialized holdout firms refined strategies to maximize payments from emerging markets muddling through crises. For example, in the late 1990s, Elliot & Associates—the firm at the forefront of the legal battle with Argentina—accumulated US$17.5 million in stressed Panamanian debt at well below face value.

The firm proceeded to win legal claims that threatened Panama’s international assets and that would have blocked a bond series slated for issuance in the United States. Cornered, Panama saw little choice but to pay Elliot over US$57 million in 1996—tripling the firm’s investment in less than two years.

While the Brazil and Panama cases proved the holdout strategy could yield superior settlement terms, the specific game-changing approach subsequently employed against Argentina has its roots in Elliot Associates vs Banco de la Nación de Perú, a case litigated in the late-1990s.

In early 1996, even as the Panamanian case continued under litigation, Elliot began amassing discounted Peruvian debt dating back to 1983. True to form, the hedge fund “held out” from restructuring negotiations, and the case wended through the US court system until a New York District Court, on remand from the US Court of Appeals, awarded Elliot more than US$55 million—a 500 percent yield on Elliot’s investment—in 1999.

Elliot now had the ruling, but faced the familiar challenge of enforcement. Unlike in the Panama case, for example, Peru did not have easily attachable assets vulnerable outside of Peru.

At least no assets in a traditional sense.

In a unique twist, instead of moving against the debtor, Elliot exposed vulnerability in the other creditors who were slated to be paid by Peru via US and European banks. As Peru prepared to service restructured debt, Elliot petitioned a Belgian court arguing that the payment “of some debt contracts and not others” violated the pari passu clause, then a common boiler-plate amendment to sovereign debt.

Essentially, Elliot challenged the legality of paying restructured debt without servicing holdouts. When the Belgian court accepted this interpretation, Elliot could thus intercept Peruvian payments to the restructured debt holders. Blocked from making scheduled interest payments, Peru faced a choice between settling with Elliot or slipping back into default. Within weeks, Peru settled with Elliot, paying a whopping US$58 million.

At the time, some debt experts dismissed concerns that this outcome could be a game changer.

The court’s “broad” interpretation of parri passu contrasted with the more conventional understanding. Moreover, global heavy weights publicly dissented with the interpretation—the US, IMF and other major countries such as France issued amicus briefs to the court challenging the interpretation of parri passu. Many thought the more common interpretation of the clause would prevail.

In retrospect, however, Elliot’s case against Peru demonstrated a new strategy that could potentially make sovereign debt enforceable, thus tilting the delicate balance between sovereigns and creditors in the favor of creditors.

Thus, by fall of 2000, as Standard & Poor’s placed Argentina on credit watch, the holdout firms had a winning streak and a new blueprint for action against whichever country should happen to falter next.

That country just so happened to be Argentina.