On Monday, June 16, the US Supreme Court rang the curtain down on two key parts of the drama surrounding Argentina and its creditors, which had dragged on since the country’s debt default in 2001. First, the Court refused [pdf] to review decisions by the federal appeals court for the Second Circuit in New York, ordering Argentina to pay creditors holding defaulted bonds in full whenever it pays its new restructured bonds. The next payment on the restructured bonds is scheduled for June 30. Second, in a separate case involving the same parties, argued before the Supreme Court in April, the Court ruled 7–1 to let creditors subpoena banks for information about Argentina’s assets around the world—even if these assets later turn out to be immune from seizure by the courts.
The opinion was written by Justice Scalia; [pdf] Justice Ginsburg was the lone dissenter. Justice Sotomayor took no part in either decision. The first decision pointedly ignored interventions by Brazil, France, Mexico, Euroclear, the Jubilee Movement, and Nobel Laureate Joseph Stiglitz, among others. The second decision rejected arguments by the United States about the potential harm of allowing creditors unfettered discovery.
The two decisions together highlight the limits of US courts’ tolerance of foreign governments using sovereignty to avoid their contracts. However the decisions do not guarantee that the creditors would be paid. Instead, they bless a debt enforcement regime that relies on sanctioning third parties who deal with the sovereign in default. This new regime is based on the idea that dealing with a defaulted sovereign will become so risky and expensive that it is simply not worth it. As a result, the country will become a financial pariah, unable to do basic financial business outside its borders. In sum, the decisions leave the prevailing system for sovereign debt management badly shaken. What happens between Argentina and its creditors from now on is not nearly as important as the way in which the international financial system adapts to the new reality.
In this new reality, governments trying to restructure New York–law debt contracts have less scope to threaten default. In the past, a government could tell creditors that if they did not accept its restructuring offer, they could be stuck in default without recourse. After the Supreme Court refused to disturb the Second Circuit decisions, a government launching a debt restructuring should expect creditors who refuse to try blocking payments to the participating creditors. Participating creditors will worry that their payments might be blocked, and will seek compensation for the risk. Pending litigation against Grenada may limit this risk to a subset of debtors, but not yet.
After the Supreme Court decisions, financial market service providers have become sovereign debt enforcement agents. Clearinghouses, banks, trustees, and fiscal agents in and outside the United States dealing with a government in default under its New York debt contracts should expect orders and subpoenas targeting the sovereign’s assets and activities anywhere and everywhere.
Creditors who previously held unenforceable debt now have a promising tool to sanction a defaulting sovereign, though this does not guarantee that they will collect what they are owed. If dealing with a sovereign in default is a headache for market participants, many will avoid it, or will charge more for it. The result is an effective boycott. It becomes so costly for a sovereign to live a normal financial life outside its borders that it just pays up. As with any boycott, the pain threshold is in large part a function of domestic politics.
In sum, Argentina and its most determined creditors have destabilized the sovereign debt management system, which has relied on informal customs, ad-hoc problem solving, and sovereign immunity in lieu of sovereign bankruptcy. It remains unclear how the system will adapt to a world where sovereign debt is enforceable, albeit indirectly, by threatening to harm a wide range of third parties.
To be sure, Argentina and its creditors will keep fighting smaller battles in the lower federal courts for the next few months. These will have to do with timing (when will the court order payments to holdout creditors?) and Argentina’s attempts to get around the injunction to keep paying the restructured bonds—something President Cristina Fernandez de Kirchner promised to do again in her speech reacting to the decision. The timetable has become much more compressed. Federal courts at all levels have lost patience. The trial judge may now require Argentina to pay everyone by June 30 or soon thereafter, with no appetite to intervene to protect Argentina up the appellate chain. There is similarly no indication that US courts would allow Argentina to reroute its bond payments outside the United States to avoid the injunctions. The sympathy well ran dry a long time ago. All the third parties who might help Argentina do the rerouting have been warned.
In the past, Argentina had threatened to default on all its debt rather than pay the holdouts. It might still do so, though the damage to its economy would be enormous. The government’s recent settlements with investors in utilities and other creditors suggest that Argentina is more likely to settle with the bond holdouts as well. It would be hard-pressed to settle with the plaintiffs in the one case decided by the courts, however. They are owed less than $1.5 billion, while leaving close to $15 billion in similarly situated holdout debt hanging. Any deal would have to reassure the markets that all the holdout litigation is put to bed—which means settling closer to $15 billion in claims, rather than $1.5 billion. Argentina’s reserves were under $30 billion [pdf] in April, which means that any large settlement would have to be in bonds. Such a transaction would take time to design and execute, and Argentina is just about out of time.
Perhaps most important, there is no time for a face-saving political transition that would allow the current president to exit the stage and for her successor to do what she had sworn not to. The time pressure might raise the risk of inadvertent default.
Financial market service providers may in the future change their contracts and policies to limit the risk of getting caught up in another Argentina-style mess. They could demand more indemnities from governments and their creditors, but these would not be too useful when the government is in default. The better way is to refuse to handle contracts exposing them to litigation, and to have clear exit procedures if the risk materializes.
Meanwhile, the International Monetary Fund (IMF), the G-7 governments, and others in the official sector should rethink their reliance on sovereign immunity for sovereign debt restructuring. The most likely policy response will be to encourage more contract reform, to limit opportunities for Argentina-style disruption. The IMF plans a paper on contract reform shortly (a companion paper on debt restructuring policy was discussed last week). A major trade group has floated a contract reform proposal within the past year. More may come. As with any contract change, transition looms large. It is implausible that all sovereigns will exchange all their outstanding bonds for ones with new, less vulnerable terms. Thus the fallout from Second Circuit decisions will continue until the existing debt stock runs off.
On the other hand, courts in the United Kingdom, Belgium, and elsewhere are in a bind. They are not bound by the US decisions, but cannot ignore the highest court in the United States blessing a contract interpretation and a remedy that might conflict with their own jurisprudence, [pdf] or, in the case of Belgium, with national legislation shielding the Euroclear system [pdf] from the kinds of remedies issued by the New York courts. It will be interesting to see how they resolve the conflicts.
The next month or two will bring more noisy Argentina news. But the full ramifications of Argentina’s crisis and default for the global financial system are coming into focus at long last. We have a glimpse of the sovereign debt world after Argentina. [pdf] It is a world fraught with uncertainty, perhaps more so than at any time since the early 1990s. On the other hand, the Supreme Court decisions also present an opportunity for market participants and policymakers to design a better framework for sovereign debt management, one that does not rely entirely on unenforceable contracts.
A version of this essay was posted on Credit Slips.