THE FUTURE OF the international payments system is at stake, along with the smooth functioning of the Euromarkets and even the continued survival of the Bretton Woods institutions.
At the centre of this dispute is some of the most benign debt-contract language ever seen by anybody who has underwritten a Eurobond – the pari passu clause. It’s a pretty standard feature of bond documentation. Yet if the clause means what some jurists say it means, there could be wide-ranging ramifications for the wellbeing of the international financial architecture. So much so that the US government has taken the rare step of filing a friend-of-the-court brief in a civil suit in New York.
The problems began in 2000, when Elliott Associates, a creditor of Peru, was seeking mechanisms to turn a New York court judgment against Peru into actual cash. Peru had ensured that it had no easily attachable assets in the US. But it did have Brady bonds issued there, and the bonds had coupons.
Elliott’s argument, for all its novelty, was simple. All Peru’s external indebtedness ranked pari passu in priority of payment. This meant that Peru couldn’t pay some of its external bondholders without paying Elliott at the same time. Essentially, Elliott was asserting that the pari passu clause had all the functions of a sharing clause, forcing equally ranked creditors to be paid equally.
As New York University law professor Andreas Lowenfeld famously put it in a declaration commissioned by Elliott: “A borrower from Tom, Dick, and Harry can’t say ‘I will pay Tom and Dick in full, and if there is anything left over I’ll pay Harry’. If there is not enough money to go around, the borrower faced with a pari passu provision must pay all three of them on the same basis.”
This was a novel interpretation of the pari passu clause. But it did the job: the New York court issued an order intended to freeze Peru’s Brady coupon payments. Rather than fight the order, Peru decided to pay the coupons through Euroclear in Belgium instead.
Unfortunately, what was becoming known as the Lowenfeld interpretation had as much success in Brussels as in New York. The Belgian opinion said: “The various creditors benefit from a pari passu clause that in effect provides that the debt must be repaid pro rata among all creditors.” Before Peru could appeal, its president was ousted and the new government decided to settle out of court.
In the years since Elliott v Peru, the “ratable payment” interpretation of the pari passu clause has refused to go away. A case in California involving the Congo followed the same path, and recently Nicaragua’s feet were being held to the fire by shadowy creditor LNC in exactly the way that Peru’s were by Elliott.
Overshadowing all these relatively minor countries is the one that is really keeping observers up at night – Argentina.
If Argentina is not allowed to pay the butcher without paying the baker, all manner of problems might arise. Normal sovereign actions like staying current on trade credit become, arguably, illegal, so long as some bondholders remain in default. Again, as the New York Clearing House noted in a friend-of-the-court brief, any such interpretation “would threaten the reliable functioning of international payment systems”. A cascade of lawsuits, with creditors falling over each other to attach banks’ and each other’s payment streams, “would inhibit the free flow of funds among financial institutions, create uncertainty as to rights and liabilities, and place intermediary banks in the middle of civil disputes”.
Such a reading would make it effectively impossible for Argentina – or any sovereign – to restructure its debts. If hold-outs to any deal had to be paid pari passu with bondholders who entered into an exchange and took a write-down on their debt, no-one would ever exchange their bonds and no restructuring could ever get done.
And to top it all off, the new reading would place even payments to the international financial institutions (IFIs) at risk. While the IMF and World Bank are generally agreed to have preferred-creditor status, legally they rank pari passu with every other external creditor. This has whipped up a minor panic in the IMF and among its shareholders – especially the US.
Pleading the IFIs’ role As the US says in its own friend-of-the-court brief: “Both policy and equity require that sovereigns be permitted to service their IFI obligations. An interruption of the financial transactions between the IFIs, especially the IMF, and their members would substantially undermine the ability of the IFIs to fulfil their vital systematic public policy functions in promoting international economic and financial stability.” The brief was filed in January by the US attorney for the southern district of New York; it comprises input from the Treasury, State and Justice departments.
The Treasury is worried because no court has yet agreed with the US government and the New York Clearing House on this matter. Their briefs were filed in a case under way in a New York court, where Argentina was seeking pre-emptively to prevent its creditors from taking the Elliott path. In oral conference, the judge, Thomas Griesa, seemed well disposed towards Argentina’s interpretation of the clause, but nevertheless refused to rule on it, agreeing with the Emerging Market Creditors Association that the matter was simply not justiciable. Essentially, whatever the merits of the case, Griesa determined that the issue wasn’t ripe for adjudication in a US court of law, since none of the creditors in front of him had actually made Lowenfeld’s pari passu argument, or tried to attach funds using it.
A similar outcome concluded the Nicaragua case in Brussels: a Belgian appeals court essentially ducked the issue, refusing to rule on what the pari passu clause means. However, the court did rule that even if Lowenfeld is right, Euroclear can’t be forced to hand over money to judgment creditors: while Nicaragua might have to pay all creditors equally, Euroclear doesn’t, and LNC’s attempts to duplicate Elliott’s achievement were thwarted. As Michael Chamberlin, executive director of EMTA, the Emerging Markets Traders Association, says, “if nothing else, this must certainly be a great relief to Euroclear”.
Nevertheless, when it comes to deciding what the pari passu clause actually means, all recent precedent, in both US and Belgian courts, implies that Lowenfeld and Elliott were correct in their broad reading of the clause. The battle lines seem to be pretty clearly drawn. “I feel the correct interpretation as a legal matter is the narrow interpretation,” says Chamberlin, “which puts me in agreement with every lawyer whose views I respect.”
Certainly, all the lawyers who drafted these clauses in the first place seem to agree that they don’t mean what Lowenfeld says they mean. As Troland Link, senior counsel at Davis Polk, says in a declaration to the Brussels court: “The purpose served by the pari passu clause in a sovereign context is to ensure that the debt covered will not be subordinated, by law or contract, to a senior payment right of any other class of debt.” Cleary Gottlieb partner Lee Buchheit probably knows more about the history and meaning of the clause than anybody else. His paper on the subject is exhaustive, but even he admits that “the oracular nature of the clause” can “tempt someone to speculate about alternative meanings”.
The problem is that, in a sovereign context, the clause actually means almost nothing – at least if you follow Buchheit. It serves a useful purpose in the corporate context, where ranking of debts is necessary if there is bankruptcy. But sovereigns don’t go bankrupt: they default.
Buchheit constructs a plausible history of why the clause exists in sovereign bonds and what the drafters were thinking of when they included it. But he spends almost no time looking at the “black letter” of the clause, which is where Lowenfeld begins and ends his analysis. “Contracts mean what the parties intend them to mean,” says Buchheit. “In the case of boilerplate contractual provisions, the clauses carry the meaning accepted by general consensus among market participants.”
Not so, says Hal Scott, a Harvard law professor who has, along with Lowenfeld, filed a declaration in Brussels supporting the broad reading of the clause. “New York law requires that this clause be interpreted according to its ‘plain meaning’, under which clear contract language should be given its plain meaning without resort to evidence about the intent of the parties,” he writes.
And so while Buchheit is quoting the prospectus for the Honduras Railway Loan of 1867, his opponents simply look at the words, assume that they must mean something, and then ask what that could be. They also ask what the difference could possibly be between bonds that simply “rank pari passu”, as some do, and bonds that “rank pari passu in priority of payment”, as others do. Why add the language referring to payment, if not to say something about payments? Scott says: “There is no difference in effect between the words ‘will rank pari passu… and will be paid as such’ and the words ‘ranking at least pari passu in priority of payment’.”
And at the moment, at least, he has quite a lot of support among creditors. In the days when Eurobonds were inviolate, bondholders would presumably have subscribed to the Buchheit reading: they wouldn’t like to think that a bank, say, might try to attach their bond coupons if one of its loans to the country defaulted.
Now, however, bonds are very much expected to be included in all sovereign restructurings, and bondholders are fighting for any rights they can get. “There’s something wrong with a system where the sovereign doesn’t have any restrictions on who it can and cannot pay,” says EMTA’s Chamberlin. “The narrow reading of the pari passu clause leaves a pretty gaping hole in the architecture.”
Nevertheless, if the international financial architecture is incomplete under a narrow reading of the clause, it’s positively rickety under a broad one.
Sooner or later, one of Argentina’s many creditors is going to try to persuade a New York court of the merits of the broad reading. The brave bondholder will be fighting against formidable foes: not only the US government, but also the combination of debtor (Argentina) and creditors (as represented by the New York Clearing House). But sometimes the little guy wins, and there are a lot of people very worried about the consequences if that should happen.
