Elena Craescu/European Pressphoto AgencyA Ghana court seized the Argentine vessel ARA Libertad in October on an injunction requested by Elliott Management.A dogged group of hedge funds secured a significant victory in a federal appeals court on Friday in a case that is likely to have far-reaching effects on international bond markets, parts of the banking system and the struggling nation of Argentina.
The hedge funds, including one affiliated with the investment firm of the billionaire Paul E. Singer, bought a handful of bonds that Argentina’s government defaulted on early in the last decade. Their aim was to buy the debt for pennies on the dollar and then sue Argentina to press it to pay the bonds in full. A lower court judge ruled in their favor, and a three-judge panel of the United States Court of Appeals for the Second Circuit in New York upheld his decision.
The funds may not be in line for a big financial return on their high-risk bet, even after the court victory on Friday. But even if their wager never pays off, the funds’ litigation strategy is bringing important changes to the international market in which many countries borrow to finance their deficits and support their economies.
The litigation could also create a situation in which Argentina, led by President Cristina Fernández de Kirchner, chooses to default on billions of dollars of bonds, a move that would deepen the country’s economic problems. Argentina has employed prominent New York lawyers to fight its case. Mrs. Kirchner has often commented combatively on the case, calling the hedge funds “vultures.”
“This is legal history in the making,” said Arturo C. Porzecanski, a professor of international economics at the American University in Washington. “The ruling, as well as the entire Argentina litigation, is really setting precedent.”
The appeals court decision has its roots in a dark period of Argentina’s recent history. Reeling from a harsh economic slowdown, Argentina defaulted on nearly $100 billion of debt in 2001. In the years afterward, many of the country’s bondholders agreed to deals in which they received new “exchange” bonds that were worth a lot less than the original ones. Argentina has kept up with the payments on the exchange bonds since it issued them.
But some investors, known as holdouts, refused to join the exchange deals and demanded full repayment. This included Mr. Singer’s firm, Elliott Management, which has sued other developing countries to make money on defaulted bonds. In the Argentina case, it even persuaded a court in Ghana to seize an Argentine naval vessel.
The funds demanded that they be paid in full on $1.3 billion of defaulted Argentine bonds, and Judge Thomas P. Griesa of Federal District Court in New York ruled forcefully in their favor.
His ruling contained two crucial features. First, he said Argentina had to pay the holdouts on their defaulted bonds whenever it next made payments on the restructured bonds. And in a move that has few precedents, Judge Griesa came up with a way to potentially enforce his decision if Argentina chose to ignore it. He singled out the financial firms that pass the payments on the restructured bonds from the Argentine government to their holders. If these firms handled the payments, they could effectively find themselves in contempt of the court’s ruling.
Not wanting to break the law, the firms, like Bank of New York Mellon, would stop processing the bond payments. Mrs. Kirchner would then have to decide whether to pay the holdouts to clear the way for the payment-processing firms to funnel money to the holders of the exchange bonds or, in the alternative, default on the exchange bonds.
Though the appeals court sided with Judge Griesa, it delayed the enforcement of the decision while the Supreme Court decides whether to take the case.
“Today’s unanimous, well-reasoned decision appropriately condemns Argentina’s persistent violation of its obligations and its extraordinary defiance of the laws of the United States,” Theodore B. Olson, a partner at Gibson, Dunn & Crutcher, the law firm that is representing an affiliate of Elliott Management, said in a statement.
“This is another opportunity for my government to do what it should do and deal in good faith,” said Horacio Vázquez, a Buenos Aires native who leads a group of bondholders who want to be repaid in full.
Elliott bought some of its Argentine debt before the country’s 2001 default, according to a person familar with the fund’s actions.
One big question is whether the appeals court decision will disrupt the sort of debt reductions that can ease the economic burdens of some countries. Investors might be emboldened to take a tough line after seeing Elliott’s legal successes.
But the appeals court argued that this Argentina case was narrow in nature, suggesting that it may not apply in other defaults. “This case is an exceptional one with little apparent bearing on transactions that can be expected in the future,” Judge Barrington D. Parker wrote in the decision.
Legal specialists who think the Argentina case won’t have a wide effect have also noted that many bonds now have a special feature that make it much harder for hedge funds to hold out.
Still, bonds continue to have a so-called pari passu clause, from the Latin for “on equal footing,” which has been crucial in this case. The clause provided the legal basis for the courts to demand that the holdouts be paid when the holders of the exchange bonds are paid.
“Everyone who has a clause like this had better look at it very carefully,” Mitu Gulati, a law professor at Duke, said.
Perhaps the most jarring development is that the appeals court upheld the provisions that are designed to stop banks from passing on payments on the exchange bonds. The government debt market lacks an authority, like a bankruptcy court, that can sort out disputes between creditors and debtors. By effectively tying the hands of firms like Bank of New York Mellon, the United States courts could become such an enforcer.
“This is the revolution in this case,” Mr. Gulati said. “For the first time in hundreds of years of sovereign debt, a court is saying, ‘We’re going to go out there and improve the market by helping you to enforce it.’ ”
The odds of Argentina getting the Supreme Court to rule on the case do not look strong.
“On the one hand, just looking at these questions as questions of law, I don’t think the Supreme Court is likely to take it up,” Henry Weisburg, a partner at Shearman & Sterling, said. “But you do have to balance this against the fact that sovereign states do get deference from the Supreme Court.”
In Argentina, Mrs. Kirchner is likely to keep up her strong opposition to the hedge funds for the foreseeable future, which means they probably won’t get paid in full any time soon.
But political analysts are starting to doubt whether she can win the 2015 election. That could pave the way for a new president who may be more willing to settle with the holdouts.
Jonathan Gilbert contributed reporting from Buenos Aires.