Part 1: Introduction

In the world of emerging market debt, the need of debtors and creditors to restructure debts has been and likely always will be an inveterate and persistent feature. The economic performance of emerging market economies tends to be volatile — beyond the effectiveness of the fiscal and monetary policies that these developing nations pursue, their economies are often subject to the vicissitudes of such external factors as world commodity prices and the monetary policies of the developed world. A previously sustainable debt profile may be rendered unsustainable for an emerging market nation for a whole host of economic, political and even “natural” reasons.

Thus, the debt restructuring process has become an integral part of the emerging debt market. This process is best if it is orderly and in the best interest of both debtors and creditors. Attempts by rogue creditors or vulture hedge funds to capture extra profits by free-riding on the restructuring process lead to economic inefficiency as the process is disrupted or sabotaged, and the costs are disproportionately incurred by debtor and the other creditors alike. Recent attempts to involve the private-sector (PSI) in the restructuring process and to effectively bail-in dissenting creditors have constituted a much-needed policy response to the harmful behavior of maverick creditors.

The current state of the debt restructuring process is conditioned by historical events. I shall therefore begin by relating how emerging market financing has experienced extraordinary flux over the past twenty-five years.

Part 2: The Evolution of Debt Restructuring in Developing Countries

1970s Commercial Bank Loans

During the 1970s, commercial banks began to lend to developing countries. This was unprecedented in the sense that it was the first time in history that the main part of development finance was coming from commercial banks — and not from investors in bonds or projects or from exporters to the region.[1] This movement towards commercial bank lending in developing countries was extremely significant. In the case of defaults on the debt-holdings, only a small group of commercial banks would be directly hurt; but because of the importance of these banks in the international financial system, defaults could create externalities and repercussions that would eventually jeopardize the viability of the entire international financial system.[2]

There are numerous possible reasons for the commercial bank lending to developing or lesser-developed countries (LDCs) that emerged during the 1970s. One involves the oil price shock of 1973. This event caused a dramatic increase in the oil revenues of OPEC (the Organization of Petroleum Exporting Countries); OPEC deposited much of its funds in Eurodollar deposits with major commercial banks (these became known as “petrodollars”). A combination of high real interest rates and a recession (in part due to the oil price shock) in the industrialized world made investment of the petrodollar funds there unviable.[3] Instead, the petrodollars were invested (or “recycled”) in the form of commercial bank loans to the LDCs. The purpose for the LDCs was to finance their balance of payments adjustment (i.e. their widening current account deficit, which was in part goaded by the rise of oil prices).[4]

How the Banks Lent: The Syndicated Loan Structure

The commercial banks lent to the LDCs under a syndicated loan structure. A syndicated loan is essentially a large loan that is made by a consortium of banks and financial institutions. However, what makes a syndicated loan distinct as a form of multibank lending is the high level of coordination between the lending banks in making such a loan: “A syndicated loan is made to a single borrower by two or more direct lending institutions, on similar terms and conditions, using common documentation and administered by a common agent bank or separate agent banks.”[5]

The implications of using the syndicated loan structure of financing are extremely important. By using loans as opposed to other forms of financing, the banks had relatively illiquid assets on the banks’ balance sheets. Unlike bonds, which are securitized and are generally liquid assets, loans tend to be difficult to trade or unload. With the banks’ high loan exposures to the LDCs (particularly with respect to their levels of capital), they essentially became tied to the economic fates of these countries.[6] Should the LDCs not be able to pay back their debts, the effects would be devastating (because of their massive loan exposures, many banks would become insolvent). And this situation was not just extremely dangerous for the banks themselves, it was also dangerous for the entire international financial system. The implication of the failure of major commercial banks extended way beyond the banks and their depositors. Massive bank failures posed a systemic risk with far-reaching external effects — i.e. bank failures would indeed lead to international financial crisis.

Reasons Why Financing Came in the Form of Loans

There are a number of possible reasons why the banks “chose” the syndicated loan structure as opposed to other forms of financing structures (namely bonds). One is that the historical experience of the bond crises during the 1930s put strict controls on international securities markets, which also helped in perpetuating the notion that institutional investors had better access to information than individual investors.[7]

Another possible reason was associated with the pecuniary advantages the banks had to lend to the LDCs. The loan structure allowed the banks to lock in a profitable spread between their assets (loans to the LDCs) and their liabilities (the petrodollar deposits).[8] This was particularly true given that the commercial banks were able to shift both the interest rate and currency risk on to the LDCs. Additionally, the major lead banks were able to generate sizeable fees for the syndication of the commercial bank debt.[9]

Syndication also limited the amount and type of creditors that could be involved. This feature of syndication had the advantage of interlinking the interests of the banks. A bond offering, for example, would have been less likely to do this, as a bond offering would have allowed a more heterogeneous and a larger group of creditors with different interests to become involved. The unification and interlinking of interests that syndication provided had the potential of being an asset in the instance of debt negotiations.

Finally, and perhaps most importantly, there was tacit support by the U.S. government for the bank lending to the LDCs. Lax regulation by the U.S. government allowed the banks to accumulate significant sovereign risk.[10] The banks ostensibly held the belief that they would receive assistance from the official sector should they incur losses on their loans.[11] The commercial banks were widely held to be ‘too big to fail’ — governments were obliged to intervene and save potentially insolvent banks in order to stave off a financial crisis.[12] The U.S. government’s rationale for bank lending apparently stemmed from its desire to see official sector funds to developing countries scaled back. The U.S. government and the governments of industrialized countries wanted to see the petrodollars recycled, but they didn’t want public organizations to do it.[13] Since the commercial banks were the recipients of the oil deposits — and were sophisticated financial institutions with the ability to lend these deposits —, they seemed the most logical actors to recycle the funds.

However, the potential benefits of this lending-borrowing relationship were not limited to the banks. The lenders (i.e. the LDCs) also needed and wanted the commercial bank loans. With the bank loans, the LDCs were able to fund their import consumption (which, as alluded to before, was increasing in part due to the rise of oil prices). The LDCs could have done possibly done this through other sources, but bank financing held distinct advantages.

During the 1950s and 1960s, financing for developing nations came primarily from official institutions such as the World Bank and the Inter-American Development Bank.[14] Unlike these funds from official sources, the bank loans had no conditions attached to them (the official sector generally promulgated that a particular LDC instituted specific economic and political policies before monetary assistance was disbursed).[15]

The 1980s Debt Crisis

Nevertheless, there were potential drawbacks to the loans that the LDCs borrowed from the commercial banks. The petrodollar loans were variable-rate and were almost exclusively dollar-denominated. This meant that the LDCs bore the interest-rate and exchange risk. During much of the 1970s, this circumstance didn’t really hurt the LDCs since they were paying low real interest rates on their debts (this was due to relatively low nominal interest rates and high rates of inflation).[16] During the late 1970s, these circumstances changed. The U.S. Federal Reserve began to tighten its monetary policy — thus driving up nominal interest rates and lowering inflation rates. This left the LDCs paying exorbitantly high real interest rates.[17] By the early 1980s, it became increasingly clear that the debt profiles of the LDCs were unsustainable.

And with the U.S. Federal Reserve’s monetary tightening and an economic recession in the industrialized countries (thus limiting their appetite for imports from the LDCs), the LDCs began to have rising interest payments on their external debt with floundering export revenues.[18] With these conditions, the LDCs were in perilous waters. The first emerging market debt crisis of the 1980s occurred in Mexico (which was the largest debtor in the developing world — the biggest recipient of the petrodollar flows). After the Mexico crisis, commercial banks were highly reluctant to extend any new financing, although eventually they would be persuaded — through the subsequent debt restructurings — to provide additional funds to avoid having their loans designated as non-performing.[19] As the capital flow to the developing world dried up, it became increasingly clear that the debt portfolios of the LDCs were unsustainable. Throughout the 1980s, exorbitant external debt burdens strangled economic growth in these economies. IMF austerity programs, which were implemented to mitigate the problems of the debt-saddled LDCs, provided short-term aid but caused long-term economic stagnancy (as the name implies, the IMF austerity plans imposed fiscal and monetary tightening on the recipients).[20] The decade of the 1980s has thus been referred to by commentators as “the lost decade” for emerging market economies. The debt restructurings during this era did little to alleviate these problems. They provided short-term, ad hoc “solutions” for a persistent and long-term problem.

The Resolution of the Debt Crisis: The Brady Plan & Economic Liberalization

In the early 1990s, a major step was made towards the mitigation of the developing world’s debt problems through the Brady Plan. The Brady Plan called for a writedown of the bank debt under the voluntary conversion of the commercial bank loans to an LDC into collateralized bonds (they would be collateralized by U.S. Treasury debt).[21] Through this securitization, “the bank loans owed by a sovereign debtor are repackaged as bonds, which are offered to the public. The proceeds of the bond offering are then used to retire the country’s outstanding bank loan indebtedness.”[22] The Brady Plan was a flexible plan that offered options to the commercial bank loan holders: these holders could choose from “a menu of Brady bond options to receive in exchange for their sovereign loan assets.”[23] The most popular choices were the par and discount bonds. By having different types of bond instruments, the Brady bonds became enticing investment choices for new groups and types of investors. These bonds were securitized and thus were much more liquid assets than the commercial bank loans. The Brady restructurings helped expand the base of investors in emerging market debt, which facilitated the expansion of the secondary market for emerging market sovereign debt.

The Brady Plan: “not only allowed the dissemination of risk across a heterogeneous pool of agents, but it also allowed economic agents to price the debt according to market, economic, and political conditions, without overburdening any particular organization. The use of market mechanisms also provided investors with rewards in return for the assumption of risk.”[24] The Brady-style restructurings were also an important step for the LDCs because under the restructurings, the debt was written down, the interest-rate risk exposure moved from the debtor nations to the creditors (because the new Brady bonds were primarily fixed-rate instruments), and the debtor nations had the ability to retire some of their sovereign debt by buying their Brady bonds on the secondary market at a discounted price. Nevertheless, despite the definite merits of it, the Brady Plan — precisely by expanding the market — created potential problems for future restructurings.

While the Brady Plan fundamentally altered the dynamics of the sovereign debt market, other innovations and developments fundamentally altered the dynamics of international capital markets, in general. International financial markets evolved, reaching unprecedented levels of sophistication during the 1990s. Many emerging market countries liberalized their economies during the late 1980s and early 1990s. This attracted capital flows from international private investors (particularly portfolio investors).[25] This influx of foreign capital helped foster further sophistication of many emerging capital markets. This capital flow into emerging markets was much different from the capital flow into the emerging markets during the 1970s. These capital flows were no longer heavily concentrated in commercial bank loans to sovereign debtors. During the 1990s, private firms in emerging market economies were selling securitized assets (i.e. stocks and bonds) to a heterogeneous group of investors; a sophisticated international interbank loan and swap market also developed to facilitate financing in developing countries; finally, much external financing in emerging market economies came in the form of relatively stable foreign direct investment.[26]

The liberalization and sophistication of international capital markets, like the Brady Plan, represented progress for the developing world and the developed world alike. But also like the Brady Plan, this progress came with its share of tribulation. The capital flows that swept through the developing world proved to be fickle. Pre-liberalization business and government structures also persisted despite movements towards liberalization. For economies just learning their gait in the midst of new capital market structures, these exigencies proved to be hazardous. And thus, throughout the latter part of the 1990s, a whole slew of financial crises developed in emerging market economies.[27]

Despite the obvious importance of these financial crises, they are not the primary emphasis of this paper. For the developments in international capital markets have produced two different types of crises. The first is the type of financial crisis alluded to in the last paragraph. The second, which is the primary focus of this paper, is with regard to sovereign debt. This type of crisis is distinguished from the sovereign debt crises of the 1980s because it involves bond debt, and not commercial bank loans. This breed of crisis that tends to occur in countries that are small and that don’t have advanced capital markets (and thus still rely primarily on lending at the sovereign level). It also tends to involve questions of insolvency (meaning that fundamentally the country cannot service its debt without a restructuring involving substantial debt forgiveness). These are the sovereign debt crises developing in the developing in the post Brady Plan environment.

The Brady Plan & the Alteration of the Dynamics of the Restructuring Process

The circumstances surrounding sovereign debt drastically changed in the wake of the Brady Plan. The development of secondary markets in emerging-market bond debt and the Brady-style restructurings of the early 1990s changed the dynamics of sovereign debt restructurings. When commercial bank syndicated loans conditioned sovereign debt lending, the restructuring of the debt tended to proceed in a relatively orderly process. The restructuring of official-sector and private-sector debt to emerging-market sovereign debtors was traditionally contingent upon the acceptance of an IMF structural adjustment program.[28] The traditional restructuring process usually began with bilateral debt negotiations between the sovereign debtor and its Paris Club lenders. The second stage was usually a restructuring of commercial bank loans (the collective group of commercial banks is commonly referred to as the London Club of commercial banks).

The lending banks had vested interests in seeing an orderly restructuring. The banks rolled over the debt to avoid declaring default on the debt (because they did not want to have bad or non-performing loans on their balance sheet).[29] They also generally had long-term interests in emerging market economies and were thus inextricably tied to the economic well-being of the countries they lent to; it was thus undoubtedly within their interests to cooperate.

Besides the banks’ self-interest in restructuring, there were also external pressures exerted upon them. During the days of a homogeneous group of creditors, there was a systematic mechanism of hegemonic influence. The commercial banks involved in the syndicated loans (and thus the financing of the debt) were subject to regulatory oversight in their home countries: the governments of developed countries were able to exert due influence upon the banks when it became necessary. Furthermore, the IMF also exerted influence on the commercial banks; the IMF only extended bridge loans to sovereign debtors on the condition that all of the country’s creditors provided bridge loans as well.[30] The banks needed continuing interest payments and time to build up loan-loss reserves; and these conditions would only be borne out by IMF involvement.[31] In addition to the external pressure, the bank creditors would also exert influence upon one another. In most defaults, a bank advisory committee (BAC) would be created, headed by twelve to fourteen of the largest bank creditors, to represent creditor interests. Regulatory pressures were imposed upon maverick bank creditors that sought to abstain or hold-out from the negotiations; these pressures basically forced any dissenting banks to agree with the restructuring.[32]

All parties were thus dependent upon one another: the banks deemed it essential that the debtor countries implement austerity programs; the debtor countries would not implement austerity programs unless the IMF extended loans; the IMF would not make loans unless the commercial banks extended bridge loans. The result of this triangular dependency was [that] action was either taken collectively or not at all.[33]

Notwithstanding the problems associated with commercial bank lending to sovereign debtors and the ultimate effectiveness of this traditional restructuring process of sovereign debt, the Brady bond restructurings altered and indeed undermined this orderly and predictable restructuring process. In 1989, the Brady Plan initiated the securitization of the defaulted loans. Banks were thus compelled to agree to a negotiated settlement; this required them to take losses on the debt due to principal write-downs or loss of interest. Subsequent to the Brady restructurings, banks found it much easier to unload the bond debt, in comparison to loans, on the secondary market.[34] Bond obligations were bought on the secondary market by a much more decentralized group of creditors. Even though a secondary market had already been developed for sovereign loans after the first wave of debt restructurings, much of the secondary market trading in the loan market was inter-bank trading; it was the Brady negotiations that truly altered the market by broadening the base of investors.

Free-Ridership and Collective Action Problems in Bond Restructurings and Exchanges

The Brady Plan solved many problems in emerging market debt as it provided liquidity and new financing, but it created a different problem — it created a potential barrier to the restructuring process. The restructuring process of bonds and loans is subject to the problems of “collective representation” and “collective action.” These problems are heightened with the movement from loans to bonds, because bondholders tend to be widely dispersed and heterogeneous. Collective representation problems refer to the procedural difficulties in organizing dialogue between the debtor and group(s) of creditors. The more pernicious problems are associated with the collective action problems. These problems arise from the “difference between the individual (private) and collective (social) returns related to a given course of action.”[35]

The collective action problems are much more pervasive in the restructuring of bonds than in the restructuring of commercial bank loans. As previously mentioned, sovereign loans had commonly been financed by a syndicate of banks. The syndicate arrangement tended to foster cooperation between banks because under this arrangement there was usually a small group of banks with relatively compatible and similar interests for making a restructuring work.[36] The commercial banks generally had very compelling interest for supporting a restructuring for the purpose of resuming the service of the debt. They did not want to declare default because this would trigger the acceleration of defaults on other debt through cross-default provisions — and thus harm their chances for recovery of the debt.[37] Banks didn’t want to have a whole portfolio of non-performing loans on their balance sheets, and were thus very hesitant about invoking defaults. Furthermore, if these reasons were not compelling enough, banks also had external pressures (from the IMF and their national governments in particular) exerted upon them during restructuring processes.[38]

Because bondholders are widely scattered, heterogeneous and autonomous, it has been seen as being difficult to compel them into participating in debt restructurings. However, the view that bondholders are immune to restructuring (because bonds may be considered legally senior to other forms of that debt because of their status as secuitized assets) and that bonds are too difficult to structure has quickly eroded over the past few years. Whether under the monikers of “bail-ins” or “burden sharing,” the official community (particularly the Paris Club, the IMF, and the World Bank) has demanded that bondholders and other private investors bear the cost of financial and economic crises in emerging market nations. These official organizations (or International Financial Institutions (IFIs)) have sought to condition their assistance upon the alacrity of private investors to bear the “costs of adjustment”; these costs can come in the form of roll-overs on maturing loans, new loans, and debt restructuring.[39] Burden sharing itself has been described as: “the notion that if debt relief is requested from any one creditor group such as official lenders and private bondholders, proportional relief should also be sought by other creditor groups.”[40] The refrain from the official lenders is that bondholders should not be privileged relative to other investors; they say that taxpayers (represented by the Paris Club) should not be obliged to compensate bondholders when their risky investments don’t pan out.[41] Despite the merits of this line of thought and despite the blustery force of this rhetoric, burden sharing in bond restructurings may still prove logistically difficult to apply or implement.

The reason once again lies in the fundamental differences in the dynamics of restructuring commercial bank loans and in the dynamics of restructuring bonds held by a heterogeneous group of bondholders. The considerations that mattered to the commercial banks in the restructurings of sovereign loans no longer do in the epoch of liquid secondary markets for emerging market sovereign bonds. Unlike in commercial bank loan markets, there is very little peer pressure in bond markets, since these actors are generally not “repeat players” and thus generally have no regard for the interests of other players in the market or for the overall systemic well-being of the market itself. “The new creditor class consists largely of pension and mutual funds, insurance companies, investment firms and sophisticated individual investors.”[42] And since these Brady bondholders generally do not constitute lending organizations, they are not obliged to give bridge loans or any additional financing.[43]

Individual bondholders thus have great incentives to free-ride during the bond restructuring process. Individual investors can buy bond obligations on the secondary market at a fraction of the full cost of the debt and then sue the sovereign in order to enforce the entire debt.[44] These investors of bond debt on the secondary market are more likely to pursue their claims by attaching the sovereign’s limited U.S. assets following a default; they are also generally not subject to the political pressures that commercial banks face to participate in a restructuring, and they may thus have great incentives to pursue the road of litigation.[45] Emerging-market sovereign bonds are usually bought at a substantial discount on the secondary market (the bonds are priced at steep discounts to reflect the bonds’ credit risk). Because of the steep price discounts individual investor may benefit substantially in the instance of a default. A default gives the secondary-market investor the opportunity to use litigation as a means to achieving debt service. Before a default, the chances that the sovereign will be able to pay the face value at maturity is slim; after a default, though, the investors gain the right to accelerate the debt and to act against the sovereign’s assets in the United States through litigation (the one wrinkle to this is that under the Brady Plan, creditors can only receive service of the principal at maturity).[46]

This free-riding by individual rogue creditors undermines the debt restructuring process. It is economically inefficient because it can potentially delay, preclude or increase the costs of a debt restructuring between a sovereign debtor and its private creditors. For even if a debt restructuring is reached in the midst of this free-riding, the participants in the restructuring (both creditors and debtor alike) are forced to bear the cost of those recalcitrant creditors who do not participate. This paper looks at cases of successful and unsuccessful actions on the part of rogue creditors in attempting to undermine the restructuring process of sovereign debt. In doing so, this analysis locates mechanisms that effectively limit or prevent this pernicious free-riding.

Part 3: Legal Case Precedents

Introduction

As sovereign emerging market debt became more liquid and tradable through the development and evolution of the secondary market, precedents of recalcitrant creditors running to the courts began to emerge. There have been a few cases in which certain creditors have refused to participate in a restructuring — and instead seek their ends through litigation; among the relevant case law are: CIBC v. Banco Central de Brasil; and Pravin Banker Associates v. Banco Popular del Peru; and Elliott Associates de la Banco de la Nacion.

CIBC v. Banco Central de Brasil

Consider first the case of CIBC v. Banco Central de Brasil. In 1988, after a series of prior debt restructurings, Brazil and its creditors entered into a Multi-Year Debt Facility Agreement (MYDFA). This restructuring covered the vast majority of Brazil’s debt to commercial bank creditors.[47] Brazil announced — only a year later — that it would not be able to service its debt under the MYDFA. In 1992, Brazil announced a Brady Plan securitization of MYFDA debt (called “the 1992 Accord”). Brazil’s creditors were given different options of bonds, for which they would exchange their existing debt. Most creditors chose collateralized par bonds, which had full service of principal but had an interest-payment write-down. After receiving the creditors’ commitments to the proposed restructuring, Brazil decided to alter the terms of the restructuring. Brazil wanted its creditors to convert at least 35% of their debt to collateralized bonds that had huge reduction in principal.[48]

In 1993, all of Brazil’s MYDFA creditors accepted these terms — all except the Dart family of Florida (known for being manufacturers of Styrofoam cups). The Dart family had been quietly accumulating Brazilian debt from creditor banks on the secondary market at discounts of 60% or more since 1991. By 1993, they accumulated $1.4 billion in Brazilian debt obligations, making them the fourth largest holder of Brazilian debt.[49] The Darts decided not to participate in the 1993 amendment to the 1992 Accord. They instead wanted to free-ride the debt restructuring by holding out for better payment terms.

When all of the other creditors agreed to restructure their MYDFA debt under the 1993 restructuring, the Darts should have been left with 100% of the existing MYFDA debt. With this status, the Darts would have been able to accelerate the debt in order to receive repayment of principal and interest (under the terms of the MYDFA, 50% of creditors was needed — in the event of a default — in order to accelerate the debt). However, Brazil saw the disruptive actions of the Darts, and coordinated a response with its central bank to combat the Darts. The Banco Central de Brasil (BDB) converted all of its MYDFA debt, except for $1.6 billion of it.[50] This was a critical amount because it precluded the Dart family from accelerating the debt (since with this action, BDB — and not the Darts Family — became the majority holder of the old MYFDA debt).

In 1994, the Darts proceeded to sue (with the Canadian Imperial Bank of Commerce (CIBC) acting as the holder of record of the debt) the central bank of Brazil. They wanted the accrued but unpaid interest (pursuant to the terms of the MYDFA) and the right to accelerate the entire principal owed.[51] U.S. government officials filed an amicus curiae brief urging the court to dismiss the Darts’ suit because of the harmful repercussions and undermining effects that such litigation has on the restructuring process of sovereign debt.[52] The court blocked the Darts’ claim for the right to accelerate the principal of the MYDFA debt but it did not dismiss their right to have the $60 million in overdue interest serviced. The case was later settled in March of 1994 as Brazil agreed to pay $25.3 million in cash on the interest that was due in October of 1994 and $52.3 million in bonds to cover the past-due interest that accrued from 1988 to 1994 on the Darts’ debt holdings.[53]

Although, the Darts’ motion to accelerate the principal was blocked, the decision ultimately worked to the Darts’ favor. The implication of the decision was that the Darts would still have their interest payments serviced and could still recover the $1.4 billion in principal upon the debt’s maturity.[54] However, the Darts did not have to wait until maturity to retrieve the principal amount. In October of 1996, the Darts cashed out of their position of Brazilian sovereign debt by issuing $1.28 billion in Eurobonds that were secured by the MYDFA debt.[55]

Thus, the Darts emerged as the victorious party. The Darts were able to achieve their ends — free-ride the debt restructuring and hold out for a better deal. They were able to accumulate Brazilian sovereign debt on the secondary market at substantial discounts. By not entering into the Brady restructuring, they were able to avoid a write-down of the principal on the Brazilian debt that they held (unlike all other creditors). Through litigation, they were able to retrieve all past-due interest payments. Through their Eurobond offering, they were able to cash out of their position in Brazilian debt with a substantial profit.

Pravin Banker Associates v. Banco Popular del Peru

The next case to consider is Pravin Banker Associates v. Banco Popular del Peru. Ever since 1984, Peru had been in technical default on its debt. Peru had not paid a payment of debt principal, and was instead merely making payments on the interest of its debt. In 1990, Pravin Banker Associates acquired $9 million in Peruvian debt (a very small amount of Peru’s foreign debt) on the secondary market at a steeply discounted price (27 cents on the dollar). They then resold all but $1.4 million of it on the secondary market. A state-owned commercial bank (Banco Popular) made interest payments directly to Pravin Banker Associates through February of 1992, at which time Pravin served the bank with a notice of default and requested full payment of principal on its debt. In December of 1992, the Peruvian government liquidated Banco Popular. Instead of participating in the liquidation procedures, Pravin Banker Associates sued Banco Popular for full principal.

Not long before Pravin Banker Associates’ motion to sue Banco Popular, a Bank Advisory Committee (BAC) had been formed to restructure $8 billion of Peru’s sovereign debt under Brady Plan negotiations. The lawsuit threatened to undermine and disrupt the debt restructuring. Additionally, Peru argued that “because Pravin had purchased Peru’s debt at a substantial discount, face value recovery upon default was not contemplated by either party, would constitute unjust enrichment, and would permit Pravin to reap a windfall profit from Peru’s economic misfortune.”[56] Pravin, on the other hand, argued that it was completely within its legal rights to seek the full-servicing of its principal — regardless of what the price it paid for the debt on the secondary market.

In this case, the court had to balance between two competing policy interests: one was that ‘the U.S. encourages participation in, and advocates the success of, IMF foreign debt resolutions under the Brady plan’; the other interest was that “the U.S. has a strong interest in ensuring the enforceability of valid debts under contract law.”[57] On January 19^th, 1996, the court rendered its decision.[58] It sided with the latter interest: it ruled in favor of Pravin Banker Associates since it would otherwise be denying them of their rights to enforce the underlying debt; according to the court, Pravin Banker Associates did not have to enter into the Brady negotiations because by their very nature, they were voluntary.[59] The court awarded Pravin approximately $2.16 million, in addition to accrued interest (from October 26, 1995), as well as any post-judgment interest that might accrue.[60]

The court also tried to extricate the case of Darts from that of Pravin, claiming that “the Darts had attempted to use litigation to amend the terms of their loan agreement. Pravin, in contrast, sought merely to enforce the terms of its agreement as written.”[61] More to the point, there were important qualitative differences between the two cases. In the Darts case, the Darts family owned $1.4 billion in Brazilian sovereign debt, whereas in this case, Pravin Banker Associates only owned $1.4 million; completely successful litigation for principal would have probably crippled Brazil’s Brady negotiations, whereas in this case, Peru’s Brady restructuring was successful despite Pravin’s success (the Pravin case represents one of nuisance litigation).[62] Undoubtedly, these circumstances were considered by the two courts in weighing the merits of their respective cases.

Despite the court’s decision to award Pravin over $2 million for full payment of principal and interest, Pravin still needed to successfully attach to Peru’s assets, pursuant to the decision. In doing so, Pravin (on June 21^st, 1996) made a motion to attach the property of Conade (a Peruvian state-owned enterprise). The court, however, rejected Pravin’s motion. The court felt that Conade was a “separate and distinct legal entity” from Peru, and thus Pravin could not attach its claim against Peru to Conade’s assets.[63] After a series of negotiations, Pravin and Peru eventually reached a settlement for an undisclosed amount[64]; ostensibly, it was for a lower amount than what Pravin was litigating for in its motion to attach to Conade’s assets.

Elliott Associates, LP v. Banco de la Nacion of Peru

The final case is that of Elliott Associates, LP v. Banco de la Nacion of Peru. Under the context of an IMF supported program, Peru announced a Brady Plan restructuring of commercial bank loans in October of 1995. Under the program, Peru would use IMF funding for the purpose of securitizing their debt (i.e. Peru would use IMF funds to buy U.S. Treasury debt securities to use as collateral for the Brady restructuring).[65] There was widespread participation in the Brady bond exchange for the defaulted commercial bank loans. However, there was a group of creditors who refused to participate in the Brady restructuring, and instead decided to hold out for better terms.

This group of investors was Elliot Associates. Elliot Associates is an investment

fund that specializes in “distressed debt” (i.e. debt that has been defaulted upon by the debtor to its creditors). Between January and March of 1996, the investment fund had purchased $20.7 million of Peruvian debt, at a discounted price of $11.4 million.[66] Elliott began purchasing this debt only after the decision of the case of Pravin Bankers v. Banco Popular del Peru, in which Pravin was able to successfully litigate against Peru. This suggested that Elliott made its purchases of Peruvian sovereign debt with the intent to sue, particularly since Elliott officials admitted to following the Pravin case (although they stated that the timing of their purchases were coincidental).[67]

On October 8^th 1996, Elliott Associates filed suit against Peru for full principal and interest on the loans it possessed.[68] The fund did not seek alternatives to suing: it did not participate in the Brady reorganization, did not offer to renegotiate, and waited until ten days before the Brady exchange was to be signed before filing suit.[69] In its suit, Elliott wanted to attach Peru’s assets to its claim. More specifically, Elliott probably wanted to attach to the US Treasury securities that Peru had purchased to use as collateral for the Brady restructuring.[70]

This case was not the first time that Elliott had tried to litigate to receive full payments on its sovereign debt claims. During 1995, Panama restructured much of its external debt under the aegis of the Brady Plan. Elliott had acquired $28.75 million (face value amount) of Panamanian sovereign loans on the secondary market for $17.5 million prior to the restructuring. Elliott refused to participate in the restructuring and instead made a motion to sue Panama for full payment on its debt. Elliott was successful in its litigation. As payment on the $17.5 of debt that Elliott had purchased, the fund received $57 million (which covered principal and accrued interest, as well as legal costs).[71]

Elliott’s case against Peru was brought to the U.S. District Court. It ruled against Elliott Associates because it felt that Elliott violated Section 489 of New York Judiciary Law (NY’s champerty law). Elliott’s suit violated this law because the fund had ‘purchased the debt with the intent and purpose to sue’ (which the champerty law expressly forbids).[72] The court felt that Elliott never seriously considered any alternatives to suing (such as entering into the Brady restructuring, selling the debt on the secondary market, or engaging in bilateral debt negotiations with Peru) when it bought its stock of Peruvian sovereign loans.[73]

However, Peru’s success at blocking the investment fund’s claim was only temporary as Elliott appealed the decision of the district court. The Second Circuit Court of Appeals reversed the decision of the district court on October 20^th, 1999 (more than a year after the federal district court’s dismissal of Elliott’s claim, which was on August 6^th, 1998).[74] The court stated that the investor was not in violation because its primary purpose was collecting the debt, not litigation (i.e. when Elliott Associates purchased the debt, their primary purpose was to enforce the debt, as the decision to litigate was ancillary).[75] In this court’s mind, the decision to litigate came only after the debtor’s “decision” not to pay. Despite the circumstantial evidence that supported the claim that Elliott purchased with the direct intent to sue (such evidence as Elliott’s history of such litigation, the timing of its decision to Peruvian debt with respect the decision of the Pravin Bankers case, and the unwillingness to seriously entertain options in lieu of suing to achieve debt service or payment), the Circuit Court remained unconvinced that Elliott’s primary intent was to sue.

The court expressed concern over the enforceability of the champerty law since it felt that this law’s application in such cases would essentially make the non-restructured debt instruments completely unenforceable after a debt restructuring. And like the court in the Pravin case, this one felt that a creditor should not be effectively forced to participate in a Brady restructuring, because this would undermine the inherently voluntary nature of Brady restructurings.[76]

In deciding the case, the court also looked at the dimensions of the over-arching policy implications at stake. On the one hand, “the enforceability of sovereign debt owed to citizens of the U.S. limits the U.S. policy in the success of IMF-backed reorganizations,” while on the other hand, “not holding the debts enforceable will dramatically reduce New York’s attractiveness as a global financial center;” the court evidently sided with the latter policy consideration.[77]

Although the overturning of the District Court’s opinion was a success for Elliott, it still needed successfully attach its claims to specific assets of Peru’s to effectively have their debt holdings paid. In cases of sovereign debt this can be difficult because sovereigns have few, if any, assets that can be attached. The reason for this is that only assets used for commercial activity in question within the jurisdiction where the suit is brought may be attached; since most sovereign assets related to borrowing are within the sovereign’s own boundaries, there are few assets to which the creditor can attach.[78]

In its attempt to successfully attach to Peru’s assets, Elliott Associates once again made recourse to the courts. Elliott Associates essentially tried to intercept the interest payment being made on Peru’s Brady bonds. The investment fund first did this by attempting to attach this payment by obtaining a restraining order from a New York court (on November 2^nd, 1999) against Peru’s fiscal agent (Chase Manhattan Bank) who was responsible for disbursing the payments. Elliott was making the argument that since the fiscal agent is the agent of the debtor — unlike the trustee, who is the agent of the creditors — these funds were still the property of Peru (and were thus attachable).[79] When Peru received word of this, the country temporarily circumvented Elliott’s attempt by stopping the transfer of funds to its fiscal agent.[80]

Once again, Elliott responded with litigation. Elliott argued in Brussels Commercial court for a restraining order to be issued against Euroclear (an international settlement system) to preclude it from either accepting funds from Peru (for the Brady bond interest payment) or from disbursing the interest payment to Peru’s creditors.[81] Elliott was basically arguing that the restraining order on the fiscal agent, should — as a corollary — also apply to the fiscal agent’s bank branches (including foreign ones) at the level of the clearing house (Euroclear).[82] This argument was rejected by the Brussels commercial court, which felt that one order of attachment cannot be applied to any transfers through a bank’s branch offices.[83]

Elliott, however, once again demonstrated its persistence in arguing for its claims in the legal arena. On June 22^nd 2000, Elliott won a decision against Peru in a New York court. The fund won a $55.7 million judgment from for principal and past due interest under the court’s decision.[84] Despite this victory, Elliott still had to attach Peru’s assets.

To do this, Elliott appealed the decision of the lower Brussels court, and the case was brought to the Court of Appeals of Brussels. On September 22^nd 2000, the Court of Appeals granted the restraining orders against both the fiscal agent (Chase) and Euroclear — which the lower court in Brussells would not grant.[85] With this decision, Peru’s hands were tied: with the restraining order, Peru effectively could not pay its Brady bondholders their interest payments without first paying Elliott its claim. Because of the Belgian court’s injunction, the financial institutions that clear their transactions under Euroclear would face stiff fines if they accepted money from Peru for the payment of interest to the Brady bondholders.[86]

Peru tried to circumvent the decision of the Brussels court by making the interest payment on its Brady bonds through the Bank of International Settlements.[87] However, it is not exactly clear how Peru could have done this. By diverting the interest payment through a foreign bank, Peru would be violating the fiscal agency agreement and the bond covenants.[88] Peru’s changing of the payment procedure (e.g. a change in the time, currency or place of payment) would be a breach of its legal contracts. Thus, this route was ultimately unsuccessful for Peru.

Furthermore, in the wake of the September 22^nd decision, Peru did not have time for elaborate action. Because of the restraining order on its fiscal agent (Chase), Peru did not make the $80 million Brady bond interest payment that was to occur on September 7^th 2000.[89] Peru had a thirty-day grace period in which to make the payment; if Peru did not make payment by the expiration of the grace period, it would be in technical default on its entire stock of Brady debt. With time running out on this grace period and mounting political problems, Peru decided to reach a settlement with Elliott for $58.4 million on October 4^th 2000 (which would allow Peru to make its interest payment before the October 7^th deadline).[90] Minus legal fees, Elliott made profits of $46.7 million on its original $11.7 million investment (equivalent to about a 400% return).[91]

The decisions in Elliott show that sovereigns have little protection from maverick creditors under the NY champerty statute (based upon the narrow judicial interpretation of it). They also show that it certainly is possible for a recalcitrant creditor to attach to a coupon payment being made on an existing bond.[92] Before Elliott’s success, it had been perceived by many legal experts that it would be nearly impossible for a maverick creditor successfully seize the assets of a sovereign debtor. The decision by the Brussels Court of Appeals severely undermined this perception of the sovereign’s safety.

A Legal Analysis of the Elliott Decision

However, it is not at all clear that the Brussels decision was based upon sound legal reasoning. In this case, Elliott made the argument that “Peru was contractually barred from paying one group of creditor (here the creditors that had agreed to the restructuring) before paying it (the holdout).”[93] Elliott argued this claim by invoking the pari passu clause (which is a standard clause in most bond indentures). Elliott essentially argued that under the mandate of the pari passu, all creditors are to rank equally in priority of payments; and that if there is not enough money to pay all creditors, “all the pari passu creditors get paid pro rata out of whatever funds are available.”[94] The Brussels appeals court accepted this argument.

However, two legal scholars (Gulati and Klee) argue that this is an invalid interpretation of the pari passu clause; in doing so, they invoke the support of a number of other scholars as well as case law. Gulati and Klee make the point that the Brussels court’s decision is not consistent with traditional understanding of the pari passu clause in corporate bond law. Additionally, in the sovereign context, it is implicit that a country having trouble servicing its debts will not want to pay all of its unsecured creditors —under the pari passu clause — on a pro rata basis; instead, as Gulati and Klee illustrate, the debtor nation will want to pay its more important unsecured creditors (namely the IMF and the World Bank) first.

Beyond the inconsistency in the Brussels court’s legal interpretation, these commentators make note of the fact that the court’s decision exacerbates the holdout problem for sovereign debtor nations. The decision legitimizes and actually promotes the behavior of free riders. Speculators are provided incentives to hold out from debt restructurings and to litigate for full payment. Indeed, if other courts accept the validity of the Brussels decision, there could indeed be a proliferation of these problems in the future of sovereign debt restructurings.

To avoid the pitfalls ever present in the Elliott case, adjustments have been made and will need to be made. To limit the maverick creditor’s ability to attach to payments being made to other creditors, a sovereign’s first line of defense is using a trustee rather than a fiscal agent.[95] Since a trustee is the agent of the creditor, a litigant will have a tougher time arguing his right to attach to the funds of the trustee (by saying that these are de facto assets of the sovereign.

With regard to limiting the pitfalls latent in the pari passu clause, Gulati and Klee recommend a number of possible remedies for the sovereign and the majority of its creditors. These include: altering the pari passu clause to say ‘pari passu with respect to priority but not payment’; using exit consents (discussed in greater detail later in the paper) to amend the pari passu clause on existing bonds; and using English Law governed bonds that have majority action clauses (which may result in a loss of business in sovereign bond underwritings for New York).[96]

Summary

The above three cases are all ones that involve litigation by recalcitrant creditors who sought to free-ride upon the debt restructurings being negotiated by the sovereign debtor and its creditors. In the Darts case, the court blocked the Darts’ claim for immediate servicing of the debt’s principal; ultimately, however, the Darts reaped a substantial profit — and effectively dodged the principal write-downs of the Brady Plan restructuring — through their litigation and subsequent Eurobond offering for the debt that they were holding. In the cases of Pravin Banker Associates and Elliot Associates, the courts ruled in favor of the maverick investors who were suing for full repayment of principal (despite having bought their debt holdings at substantial discounts on the secondary market). However, it is the Elliott case that truly represents a dangerous precedent, since Elliott was able to successfully attach to Peru’s assets to achieve a windfall profit. Nevertheless, despite the added virulence of the Elliott case, all three cases represent economic inefficiencies in which hold-out creditors were able to use litigation as a means to achieving better payoffs — at the cost of the sovereign debtor and its other creditors.

Part 4: Recent Sovereign Debt Restructurings

Introduction

The recent cases of sovereign debt exchanges and restructurings have sought to limit, constrain and eliminate pernicious litigation by dissenting creditors. The cases that I shall look at involve the restructuring of the sovereign debt of Pakistan, the Ukraine, and Ecuador. These cases were able to achieve a debt exchange that bailed in private investors and that avoided litigation by recalcitrant creditors. They are effective applications of the official sector’s demands for burden-sharing in the debt restructuring process during the era of bond financing to emerging market debtors. Ecuador is the crucial case

Emerging Market Debt & Vulture Hedge Funds:

Free-Ridership, Legal & Market Remedies

Executive Summary

Part 1: Introduction

How the Banks Lent: The Syndicated Loan Structure

Reasons Why Financing Came in the Form of Loans

The 1980s Debt Crisis

The Brady Plan & the Alteration of the Dynamics of the Restructuring Process

Part 3: Legal Case Precedents

Introduction

CIBC v. Banco Central de Brasil

A Legal Analysis of the Elliott Decision

Part 4: Recent Sovereign Debt Restructurings

Introduction