The pari passu clause as applied in Argentina sovereign bonds litigation

March 2013 | SPECIAL REPORT: DISTRESSED M&A AND INVESTING

Financier Worldwide Magazine

In a recent case US Courts gave a broad interpretation to the ‘pari passu’ clause which requires 100 percent of the principal and interest of defaulted Argentine sovereign bonds held by plaintiffs to be paid concurrently or in advance of amounts paid by Argentina under the exchange bonds issued and delivered by Argentina in 2005 and 2010 as a result of its debt restructuring.

In re NML Capital, Ltd. et al v. The Republic of Argentina the interpretation of the ‘pari passu’ clause provided under sovereign bonds issued by Argentina is being resolved by Judge Thomas Griesa of the United States District Court for the Southern District of New York and the US Court of Appeals for the Second Circuit.

The plaintiffs in this case, NML Capital, held bonds issued under a Fiscal Agency Agreement (FAA) prior to Argentina’s 2001 default (the ‘FAA Bonds’). These FAA Bonds represent a total principal and interest amount outstanding of approximately US$1.33bn.

The Argentine government conducted two exchange offers in 2005 and 2010 under which over 91 percent of the sovereign foreign indebtedness in default was restructured. Under these exchange offers, Argentina offered FAA bondholders the opportunity to exchange their defaulted bonds for new unsecured and unsubordinated external debt (the ‘Exchange Bonds’) at a rate of 25 to 29 cents on the dollar.

To induce holders to accept the exchange Argentina enacted a ‘Lock Law’ that restricts the Executive Power from reopening the exchange process and from entering into “any type of in-court, out-of court or private settlement with respect to the bonds…” Holders were also duly warned in the exchange prospectus of Argentina’s intentions to discontinue payment of the FAA Bonds.

The plaintiffs did not accept entering the exchange offers, and litigated instead.

The cornerstone argument of the plaintiffs in the NML case is that the ‘pari passu’ clause provided under the FAA Bonds requires Argentina to make payments to the plaintiffs in the event a payment will be made under the Exchange Bonds.

The Pari Passu Clause contained in the FAA provides as follows:

“[1] The Securities will constitute (…) direct, unconditional, unsecured and unsubordinated obligations of the Republic and shall at all times rank pari passu and without any preference among themselves.

[2] The payment obligation of the Republic under the Securities shall at all times rank at least equally with all its other present and future unsecured and unsubordinated External Indebtedness (…)”. This second sentence is referred to as the “Equal Treatment Provision”.

Judge Griesa agreed with the plaintiff’s claim, ruling that making payments under the Exchange Bonds while refusing to pay amounts that continue to be outstanding under the FAA Bonds constitutes a breach of the ‘pari passu’ clause. Judge Griesa subsequently issued an Injunction providing that “Whenever the Republic pays any amount due under […] the [Exchange Bonds]… the Republic shall concurrently or in advance make a ‘Ratable Payment’ to Plaintiffs. […] Such ‘Ratable Payment’ shall be an amount equal to the ‘Payment Percentage’ multiplied by the total amount currently due to [Plaintiffs]. Such ‘Payment Percentage’ shall be the fraction calculated by dividing the amount actually paid or which the Republic intends to pay under the terms of the Exchange Bonds by the total amount then due under the terms of such Exchange Bonds.”

The Court of Appeals ruled on 26 October 2012 in favour of the plaintiffs on their claim for breach of the Equal Treatment Provision, affirming Judge Griesa’s judgment ordering Argentina to make ‘Ratable Payments’ to plaintiffs concurrent with or in advance of the payments to holders of the Exchange Bonds. The Court of Appeals considered that the real dispute is over what constitutes subordination under the ‘pari passu‘ clause and concluded that “in pairing the two sentences of its Pari Passu Clause, the FAA manifested an intention to protect bondholders from more than just formal subordination. […] The first sentence of the clause prohibits Argentina, as bond issuer, from formally subordinating the bonds by issuing superior debt. The second sentence prohibits Argentina, as bond payor, from paying on other bonds without paying on the FAA Bonds. Thus, the two sentences of the Pari Passu Clause protect against different forms of discrimination: (i) the issuance of other superior debt (first sentence) and (ii) the giving of priority to other payment obligations (second sentence).” The Court of Appeals considered that restricting a sovereign as payor (the Equal Treatment Provision) makes sense as sovereigns do not enter into bankruptcy proceedings where the legal rank of debt determines the order in which creditors will be paid, but instead can choose for themselves the order in which creditors will be paid.

The Court of Appeals remanded the case to Judge Griesa for clarification of how the ‘Ratable Payment’ formula is intended to operate. The Court of Appeals considered that “It could be read to mean that if, for example, Argentina owed the holders of restructured debt $100,000 in interest and paid 100% of that amount, then it would be required to pay the plaintiffs 100% of the accelerated principal and all accrued interest. Or it could be read to mean that, if such a $100,000 payment to the exchange bondholders represented 1% of the principal and interest outstanding on the restructured debt, then Argentina must pay plaintiffs 1% of the amount owed to them.” In the first case the ‘Ratable Payments’ would be calculated based on the amounts currently due and payable under the Exchange Bonds to calculate the ‘Payment Percentage’. In the second case, the total principal and interest amount outstanding under the Exchange Bonds (even if not due and payable) would instead be used as a basis for calculation of the ‘Payment Percentage’.

On 21 November 2012, Judge Griesa ruled that “if 100% of what is currently due to the exchange bondholders is paid, then 100% of what is currently due to plaintiffs must also be paid”. He therefore considered the first hypothetical situation posed by the Court of Appeals was the one that applied. Under this interpretation, if Argentina intends to pay 100 percent of an instalment of interest or principal due at the time of payment under the Exchange Bonds, then Argentina would also be required to pay 100 percent of amounts due under the FAA Bonds held by the plaintiffs, which includes all the accelerated principal plus accrued interest. Judge Griesa’s interpretation is currently being considered by the Court of Appeals.

It would be expected that these rulings will have an impact on the viability of debt exchanges in the future. What incentives would creditors have to accept entering into a debt exchange, accepting haircuts and rescheduling of payments, if, based on the ‘pari passu’ clause of the defaulted bonds, no interest or other payments may be made to them by the debtor without a prior or concurrent payment of 100 percent of the principal, interest and other amounts owed to the holdouts? Does this interpretation of the Equal Treatment Provision not constitute a disproportionate burden for the debtor? As analysed by Judge Griesa in his 21 November 2012 ruling, Argentina making payments of interest of the Exchange Bonds in December 2012 amounting to a total of $3.14bn would require a payment of $1.33bn to the plaintiffs.

The Court of Appeals brushes off these concerns by stating that the collective action clauses which have been included in most sovereign bonds as of 2005 will effectively eliminate this type of holdout litigation in the future. As in reorganisation procedures for private entities, such collective action clauses permit the sovereign debtor to amend the terms of the bonds and to bind dissenting bondholders if a sufficient number of bondholders agree. As described by the Court of Appeals, CAC clauses have been included in “99% of the aggregate value of New York-law bonds issued since January 2005, including [the Exchange Bonds]. Only 5 of 211 issuances under New York law during that period did not include collective action clauses, and all of those issuances came from a single nation, Jamaica. Moreover, none of the bonds issued by Greece, Portugal or Spain – nations identified by Argentina as the next in line for restructuring – are governed by New York Law.”

These rulings will undoubtedly constitute case law that will be relevant when interpreting the ‘pari passu’ clause and the Equal Treatment Provision under New York Law in the future.

Ricardo W. Beller is a partner and Agustina Ranieri an associate at Marval, O’Farrell & Mairal. They can be contacted on +54 (11) 4310 0100 or by email: rwb@marval.com.ar or amr@marval.com.ar.

Ricardo W. Beller and Agustina Ranieri

Marval, O’Farrell & Mairal