The Case Against "Vulture Funds"
Sovereign debt markets are in dire need of reform. Argentina’s recent experience with “vulture funds” has been a watershed case in sovereign debt restructuring. After the U.S. Supreme Court denied the country’s appeal in 2014, Argentina presented its argument for reform to regional and international fora. Today, the UN, the IMF, and the G20, among others, are working to address this issue.
The Argentine case has brought two main issues to the forefront of the global financial agenda. First, the world has expressed its concern about the predatory behavior of vulture funds, which buy distressed debt at steep discounts on secondary markets with the goal of later litigating for its face value plus interest—sabotaging a state’s restructuring efforts and harassing good-faith creditors in the process. Such funds have devastating consequences for the stability of the global financial system.
Second, the international community has become aware that, in the absence of an international mechanism for sovereign debt restructurings, any country can be subject to vulture funds’ attacks.
This is a global problem and it needs a global solution that will ensure fair, orderly and predictable sovereign debt restructurings in the future.
Vulture Funds Profit from the Lack of a Multilateral Legal Framework
The shift from syndicated bank loans to bond markets has made the world of sovereign debt restructuring more complex. During the debt crisis in the 1980s, collective action was possible because debt was in the hands of a fairly small number of large creditors. However, the multiplication and diversification of sources, interests and claims during the twenty-first century has made the coordination of creditors much more difficult. Furthermore, the partial elimination in 2004 by the New York state legislature of the socalled “Champerty defense,”1 a law that prohibited the purchase of debt with the intent of bringing a lawsuit, favored the “litigation business.”
Vulture funds have profited from this disorder by exploiting the absence of an international sovereign bankruptcy regime. They have preyed on countries on all continents. As expressed by the Ministerial Declaration of the G77 and China in September 2013, “Vulture funds pose a risk to all future debt restructuring processes, both for developing and developed countries.”
In the case of Argentina, vulture funds managed to obtain validation from a U.S. court of an extravagant interpretation of the pari passu clause, which stated that exchange bondholders cannot receive their interest payments until vulture funds are paid in full. This is the last link in a chain of events eroding sovereign immunity.
The Argentine Case in a Nutshell
Debt is sustainable when compatible with inclusive economic growth; without economic growth, debt becomes unsustainable. Yet sovereign debt crises are a common feature of modern capitalism.
In 2001, after decades of over-indebtedness, with a debt to GDP ratio of 166 percent and in the midst of the worst economic, social and political crisis in its history, Argentina defaulted on its sovereign debt.
Since 2003, the governments of Néstor Kirchner (2003–2007) and Cristina Fernández de Kirchner (2007–present) have moved to normalize the country’s financial obligations. Undoubtedly, the most challenging step in overcoming the crisis was to restructure its debt with thousands of bondholders under seven different currencies and multiple jurisdictions.
Argentina successfully restructured its debt with 92.4 percent of its bondholders in 2005 and 2010. This was based on Argentina’s real payment capacity, and allowed creditors to become partners in the country’s prosperity by incorporating GDP linked coupons.
However, a small minority of bondholders, mainly vulture funds, chose to hold out from the debt exchange. These vulture funds bought Argentine debt after the default and judicially harassed Argentina to obtain an exorbitant 1,600 percent profit.
Argentina’s waiver of immunity has never included a waiver of its sovereign power to restructure public debt in cases of serious insolvency. However, in a highly controversial decision, the U.S. judicial system upheld the litigants’ request. Circumventing the sovereign immunities all nations have in the U.S. under the Foreign Sovereign Immunities Act (FSIA) and under international law, the ruling blocked 92.4 percent of Argentina’s exchange bondholders from collecting the payments made by the country. Financial Times chief economics commentator Martin Wolf put it bluntly: “This is extortion backed by the U.S. judiciary.”2
Argentina has warned that the unwarranted interpretation by U.S. courts contradicts international law, violates third party rights and goes against well-established fi nancial practices and common sense. By blocking the collection of payments by creditors unrelated to the litigation, the courts have empowered holdouts to sabotage future sovereign debt restructurings, rendering them impossible in the future.
In its brief filed before the New York Court of Appeals for the Second Circuit (2012), the U.S. government stated that “the district court’s interpretation of the pari passu provision could enable a single creditor to thwart the implementation of an internationally supported restructuring plan, and thereby undermine the decades of effort the United States has expended to encourage a system of cooperative resolution of sovereign debt crises.”3 As published by the Brookings Institution,4 this may be “[…] the first broadly replicable remedy against sovereign debtors since the days of gunboat diplomacy a century ago.”
As events in Europe have shown, debt crises are not limited to developing countries. In the Greek case, during the 2012 debt swap, holdouts blocked the restructuring of about 6.5 million euros in debt bonds and managed to get paid in full. They did not even have to litigate. At a global level, a recent McKinsey study concludes that since 2008, debt growth has outpaced GDP growth, raising the ratio of debt to GDP by 17 percentage points.5
The need for an international mechanism for sovereign debt restructurings is now more urgent than ever.
The World Needs a Framework for Sovereign Debt Restructurings
Recent international developments springing from the Argentine case have already produced changes in sovereign debt markets, and more are to come. Led by the IMF, a market approach to improve debt contracts is under way. More than 10 countries have already issued new debt containing so-called “vulture-proof” clauses. While propositions to modify standard contractual provisions used in sovereign debt instruments are a positive and important step forward, they are insufficient to comprehensively solve the multiple and complex challenges posed by sovereign debt restructurings.
The IMF estimates there is an existing stock of $900 billion in international sovereign bonds that do not have such improved clauses. And there can be no guarantee that novel judicial interpretations, which contradict the spirit of these clauses, as with Argentina, will not be crafted in the future. There are no fully “vulture-proof” clauses.
This is why the international community must establish a multilateral legal framework for sovereign debt restructuring processes. Promoted by the G77 and China, the UN is already debating and moving to toward the establishment of this legal framework. Last September, with the support of 124 countries, the UN adopted resolution A/RES/68/304 “to elaborate and adopt […] a multilateral legal framework for sovereign debt restructuring processes with a view, inter alia, to increasing the efficiency, stability and predictability of the international financial system.”
International experts and country representatives are working on a framework so that countries do not have to mortgage their future and the well-being of their people to the greed of vulture funds. This is a unique opportunity to contribute to a more orderly, predictable and sustainable global financial architecture. We must seize it, before it is too late.