A fierce battle between the government of Argentina and hedge funds and other investors led by a group of hedge funds has already led to the seizure of a naval ship and dragged in the United States Treasury. Now a federal appeals court is hearing the dispute, and how it rules could have a major impact on world debt markets.
The investors — including the hedge fund tycoon Paul E. Singer — sued Argentina seeking payment for $1.3 billion relating to bonds that the country defaulted on in 2001. On Wednesday, the case comes before the United States Court of Appeals for the Second Circuit, which has already sided with the hedge funds on their main arguments.
But the issue that the appeals court is still undecided about is perhaps the most important. It involves devising a method to pressure Argentina to pay up on the disputed bonds. And that has left the investors who hold a majority of Argentina’s foreign debt vulnerable, as well as the banks that process the payments to those investors.
While the hedge funds have grabbed the headlines — winning a temporary court order to seize an Argentine naval ship docked in Ghana, for example — most of the other holders of Argentina’s nearly $100 billion in defaulted debt agreed over the last decade to accept new bonds, taking big losses in the process. The country has since faithfully paid on the exchange bonds.
At the same time, Argentina has vehemently repeated that it will not pay the hedge funds and other holders of its old debt and has passed laws forbidding the government from paying anything to the bondholders who didn’t participate in the exchanges.
But last year, Judge Thomas P. Griesa of the Federal District Court in Manhattan ruled that if Argentina wanted to pay the holders of the restructured debt, it would have to pay the hedge funds and other holders of the defaulted debt, too. The judge included third-party banks in his injunction, and prohibited them from processing payments to holders of the exchange bonds unless all debt holders were paid.
Large banks, investors and the United States Treasury Department have objected to the judge’s order. In short, they say, using the sanction could cause financial losses for innocent bystanders and lead to unnecessary disruption in the bond markets.
“They are trying to block the payments system,” said Vladimir Werning, executive director for Latin American research at JPMorgan Chase. “This is unprecedented in the New York jurisdiction.”
In an e-mail, Kevin Heine, a spokesman for Bank of New York Mellon, which handles bond payments, said the ruling, “will create unrest in the credit markets and result in cascades of litigation, which is precisely the opposite effect that an injunction should have.”
A ruling in favor of the hedge funds would also have ripple effects throughout the debt markets.
“Any time you have something that can change of balance of power, it can matter beyond Argentina,” said Robert Kahn, a fellow at the Council on Foreign Relations.
Despite the legal worries, investors have so far been keen to hold higher-yielding emerging markets debt, given that interest rates are so low. Apart from Argentine bonds, debt issued by developing countries has performed strongly.
Unlike Argentina, some countries have held their noses and cut deals with holdouts in the past to get on with important economic overhauls, most recently Greece on certain smaller foreign-law bonds.
And in the years since Argentina’s default, most sovereign bonds have special clauses in them that make it much harder for holdouts to succeed. These are called collective action clauses, which state that if a certain majority of bondholders agree to take losses in a bond restructuring, those losses would be forced on all bondholders, even would-be holdouts who don’t agree.
But large amounts of bonds, those issued more than 10 years ago, do not have collective action clauses. And those that do have the clauses may not act as intended if the holdouts win their Argentina case, said Mr. Werning of JPMorgan.
Right now, a bond with a collective action clause might get restructured if 75 percent of the holders agree to it. If Judge Griesa’s ruling is upheld, more bondholders might be reluctant to enter a restructuring and the required majority might not be achieved. Bondholders might not enter the restructuring because they fear holdout litigation depriving them of payments later on.
“This could adversely affect the level of participation in a swap,” Mr. Werning said.
Still, others contend that the market for sovereign debt may be improved if the judge’s ruling is upheld, with the sanction on payments banks mostly intact. Countries like Argentina, they say, have taken advantage of the fact that there is no bankruptcy regime in the sovereign debt market to allow creditors to recoup money in a default. Indeed, Judge Griesa has said the Argentina case is partly about creating safeguards for creditors in the absence of bankruptcy regime.
But Anna Gelpern, a professor at the Washington College of Law at the American University, said that if the federal court’s rulings are upheld, it might just end up underscoring the limitations of the American courts’ power.
“What if Argentina still doesn’t settle? How does the court look then?” she said. “It can only isolate Argentina and Argentina seems content to be isolated.”
While there is a chance that the appellate court’s decision could be appealed to the United States Supreme Court, it is more likely that its ruling will be the final word on the lower court order.
According to that order, if a bank chose to channel payments from Argentina to the owners of the restructured debt, the bank would not be in compliance with his order. A payments bank, Bank of New York Mellon in the case of Argentine exchange bonds, would then decline to process the exchange bond payments, and the bonds could fall into default, inflicting big losses on their holders.
Some market specialists have raised the prospect that Argentina could keep paying the exchange bondholders by avoiding payments banks that operate in the United States. It could, for instance, swap the exchange bonds for new instruments registered under Argentine law that make payments through an Argentine entity.
But the court may decide that, in such a situation, the exchange bondholders themselves would be breaking its injunction. One of the things the appeals court is looking into is how to determine which third parties should sit outside the reach of the district court’s ruling.
It is not just hedge funds who are hoping to gain from an affirmation of the lower court ruling. This group also includes many individual investors, who are now feeling more optimistic about getting their money back as the case comes before the appeals court.
“We are hopeful the ruling will stay as issued,” said Horacio Vázquez, who helps lead a group in Buenos Aires that represents bondholders.
