Argentina’s Case Has No Victors, Many Losers

The winners have gained nothing.

The losers have lost nothing.

The innocent bystanders are worried and are scrambling to avoid becoming the real losers.

The United States judicial system may turn out to have greatly overreached its authority and be forced to back down.

The world of sovereign debt — loans to countries — was turned on its head by the victory of hedge funds led by Elliott Management over Argentina. Judge Thomas P. Griesa of Federal District Court in Manhattan ruled two years ago that Argentina, which defaulted in 2001, had to pay its bonds in full, including back interest, to investors who had refused to exchange them for new ones in a debt restructuring. If it did not, then the country could not pay interest on the new bonds.

His decision was upheld by the United States Court of Appeals for the Second Circuit, which turned aside pleas by the Justice Department and the International Monetary Fund that the decision be reversed. In June, the Supreme Court refused to hear the case. The judge’s ruling stood.

Five months later, Argentina has not paid any money to the hedge funds. The judge has succeeded in blocking it from paying any money to holders of other bonds, but that just increases the number of losers.

In a way, the current fight is reminiscent of the battles more than 300 years ago in the American colonies over debtor’s prisons, which were widespread. Such punishment might have made sense for deadbeats, and it presumably had a deterrent effect, but prisoners were unable to earn the money needed to pay their creditors even if they wished to do so.

As the Rhode Island General Assembly reported in 1747, “men of honest minds and virtuous dispositions have been reduced by misfortune (notwithstanding their utmost care and diligence) and thrown into prison, where they have been closely confined in scanty little rooms, under lock and key, to the prejudice of their health and ruin of their families, many of them being of such occupations, that if they had the liberty of the house, they could at least support themselves and families by their business.”

The solution adopted by the assembly was not to get rid of debtor’s prisons. Instead, it allowed prisoners to leave each day to work. Not until 1898 was a nationwide bankruptcy system established.

Now people and businesses can file for bankruptcy and persuade a judge to cancel or reduce some debts. In the United States, cities can go bankrupt and reduce some obligations, as Detroit did this month. But there is no similar system for countries.

More than a decade ago, after the Asian financial crisis, the International Monetary Fund proposed a sovereign debt restructuring mechanism for countries, but the United States and other countries rejected the idea as a violation of sovereignty.

In the wake of the Argentine ruling, the United Nations General Assembly tried to revive the effort, passing a resolution by a seemingly overwhelming vote of 124 to 11, with 41 countries abstaining.

The catch is that the countries that matter the most, including the United States, opposed the resolution even after it was watered down. In terms of voting power at the International Monetary Fund, the vote was 35 percent in favor, 39 percent against and the remainder abstaining. The idea is going nowhere.

For international bonds issued under New York law, as many are, it used to be that a country that defaulted could be sued and the courts would order it to pay. But sovereign immunity meant that decision could not be enforced. So most bondholders would eventually agree to some sort of debt restructuring, often involving the International Monetary Fund.

The Argentine ruling has clearly given bondholders an incentive to hold out in future international restructurings. Under Judge Griesa’s ruling, holdouts could do much better than those who agreed to the restructuring, and could not do worse.

If, that is, the decision can be enforced.

The judge, aware of that problem, has barred banks and other financial firms from doing anything to help Argentina evade the ruling. That has meant extending the ruling to cover not only bonds issued under New York law but also those issued under English and Argentine laws.

Argentina has tried to pay interest on the new bonds, but banks unwilling to violate the judge’s orders have refused to do so in London as well as in New York. In Argentina, the local Citibank branch has persuaded the judge to agree to allow three interest payments on those bonds, but he has not promised to allow future payments.

Owners of the English-law bonds are trying to persuade a British court to order the banks to pay the money. If that happens, the banks could be in a position of having to decide which court order to obey.

Argentina says it will try to exchange the New York-law bonds — over which Judge Griesa clearly has jurisdiction — for new bonds issued under Argentine law. But some bondholders fear that by accepting such an exchange they might be deemed in violation of the judge’s order. We could have the spectacle of a bondholder being held in contempt of court for accepting an interest payment.

In corporate bankruptcies, creditors that must lose money on their loans are often given equity in the company that will emerge, offering at least a possibility of a better recovery if the restructured company prospers.

You can’t get stock in a country, but Argentina tried something similar. Its exchange bonds included provisions increasing the return if the country’s economy grew rapidly enough. It did, and bondholders have done better than it appeared they would initially.

It is not clear how broadly the Argentine precedent will be applied in future cases. The appeals court, in upholding Judge Griesa’s ruling, listed several actions taken by Argentina that it considered outrageous. But it did not clarify whether a country that committed only some, or even none, of those acts could be sure that it would not be treated in the same way.

Those who back Judge Griesa tend to see the issue as a matter of black and white. Argentina promised to pay, and it must honor its promises. Those appalled by the judge’s decision are more inclined to, in effect, worry about those Rhode Island “men of honest minds and virtuous dispositions” who were suffering through no fault of their own.

At a conference at Columbia University this week, Joseph E. Stiglitz, the Columbia economist who was previously the chief economist of the World Bank, said fairness required that all creditors, not just bondholders, be considered when weighing what should happen to a country that cannot pay its bills. That list of creditors would include pension recipients in the country, who might have to go hungry so that a hedge fund could make a large profit on bonds it bought at a deep discount after the country defaulted.

With no international bankruptcy law in the offing, the United States government has encouraged countries to change the terms of new bonds they issue. Bonds recently issued by Vietnam, Kazakhstan and Mexico have included language aimed at avoiding a similar interpretation of the law and have clauses that would allow a supermajority of bondholders to force holdouts to accept a restructuring.

But it will be decades before all outstanding international bonds mature and can be replaced by bonds with the new provisions, and it is not certain those provisions would be sufficient to keep holdouts from blocking a needed restructuring.

At first glance, Judge Griesa’s ruling might be seen to promote financial rectitude by deterring countries from taking on debt they might not be able to repay. But the reverse could be true if lenders decided that the legal protection assured that even bad loans would eventually have to be repaid.

Something like that seems to have happened in the United States after Congress amended the bankruptcy law in 2005 to make it much harder for bankrupt consumers to cancel credit-card debts. Standards for lending declined, and banks suffered large losses on loans given to consumers who could not pay, no matter what a judge might say.

Judge Griesa has said repeatedly that Argentina should simply negotiate a settlement with the hedge fund holdouts. But even if the country were willing and able to do so, it is hard to see how such a deal could bind other holdouts, who could file their own legal actions seeking full payment.

The courts have ruled. So far their decisions have accomplished nothing other than enriching a lot of lawyers.