Recently, a resonant legal victory of hedge funds over Argentina has captured the attention of the global community. The hedge funds in this case aren’t run of the mill investment shops, however. Popularly known as vulture funds, their modus operandi is to buy up the debt of countries suffering crises at bargain prices, only to fiercely litigate with them afterwards. They attempt to claim full payment—principal and interest—employing a variety of tactics (including hiring lobbyists) to put pressure on the distressed debtors to satisfy their claims. And in the wake of Argentina’s loss, Puerto Rico may be in their crosshairs next.
It may not seem to matter whether a sovereign debt crisis is resolved quickly or not, but in fact delays in resolution are bad for almost everyone involved. They worsen the situation of the country in distress, and dim prospects for creditors to recover their investments. The small group of notorious Wall Street vulture funds have seized on these national crises to create extraordinary business opportunities for themselves. Over the past twenty years, these companies have raked in billions by undercutting orderly operation of the world’s financial markets.
The saga with Argentina started when the country defaulted on its debt in 2001, in the midst of the worst economic and social crisis of its history. After the default, a group of hedge funds that included NML Capital (a subsidiary of Elliot Management, which we’ll talk about again later), Aurelius Capital Management, Dart Management, Blue Angel Capital, Bracebridge Capital, Olifant Fund, and Montreux Partners bought Argentine defaulted bonds in secondary markets on the cheap. NML, for instance, paid an average price of about 27 cents on the dollar over its declared purchases. They litigated in New York courts, demanding the country pay the full face value and the interest rate that had been included in the terms of the original contracts. Due to the well-known default risks, the interest rates were high, about 10% per year on most contracts; in one of the bond series, FRAN, interest rate was linked to the country default risk, and after the default the contracted annual interest rate skyrocketed to 101%.
And they won. In 2012, Judge T. Griesa (from the Southern District of New York) ruled in their favor. Following the default, and two rounds of restructuring (in 2005 and 2010), 93% of the country’s bondholders accepted new bonds in exchange of the defaulted ones with a discount of about two-thirds. Griesa’s decision, besides creating an enormous inequity among the different bondholders, also violated the right of the restructured bondholders to get paid, as upon the vultures’ request he granted an injunction that prohibited any payment to those bondholders until the vultures got paid in full (in 2014 the US Supreme Court declined to review the case). Last April, Argentina finally settled. NML, the leading litigant, made more than $2 billion, a return of over 1,200%. The others (including non-vulture holdout creditors) also made handsome profits.
Describing these hedge funds as “vultures” is likely unfair to the actual birds. Vultures, at least, play an important role in the ecosystem. These Wall Street vultures, on the other hand, play no positive role for the functioning of the international financial system. Instead they undermine it, impeding the finalization of sovereign debt restructurings that are needed for countries in deep distress to put their economies back on track.
Unfortunately, the tactics used in Argentina are not new; Argentina’s case was simply bigger. Astonishingly, what these companies do is legal. But they also helped shape the laws that make it legal.
Indeed, there used to be a law that prohibited this behavior—the so-called Champerty defense, which prohibited the purchase of debt in default with the intent of suing the issuer. In 1998, however, Elliot Management, the same hedge fund that led the dispute against Argentina and that had bought Peruvian debt in default, sued the country and won. The case set an awful precedent.
In 2004, vultures obtained an even larger victory: Champerty was eliminated from New York State legislation for transactions greater than $500,000. New York State senator John Marchi presented the bill and it passed, despite evidence of alleged connections between the vulture hedge fund and the politician: On Mar. 25, 2004, Paul Singer, head of Elliott, made a donation to a group affiliated with the politician.
Not surprisingly, litigation in sovereign defaults has increased steadily in the past decade. But the vultures’ victory over Argentina represents a new low, both legally and ethically. Why, going forward, would any bondholder agree to a discounted rate of return if there’s a chance to be a holdout and collect returns that are orders of magnitude greater?
More often than not, sovereign debt restructurings are not deep enough to restore a national economy’s capacity for growth. But they are the best worst option for governments in desperate situations. The vultures’ most recent victory will only aggravate this problem, as debtor countries will become more prone to settle on terms even friendlier for creditors, even if those terms do not restore debt sustainability. The end of the commodity boom means we’re likely to see more countries put in this position.
More recently, Puerto Rico—not a sovereign nation—has found itself in a severe debt spiral. Even though Puerto Rico is a US territory, the US Bankruptcy Code does not extend to the island—which would make the restructuring process that the country desperately needs chaotic and difficult to finalize. This would be the perfect land for vulture funds.
Puerto Rico has been trying hard to convince the US to extend the bankruptcy law to include the territory, but so far it has not succeeded. Unsurprisingly, some hedge funds have been lobbying against this legal change. Puerto Rico also tried to enact its own bankruptcy law, but following a demand from Oppenheimer Funds and Franklin Templeton Investments, the Federal Court in Puerto Rico and the US Court of Appeals for the First Circuit declared any such law unconstitutional—and on June 13 the US Supreme Court affirmed the decision. The US Congress has now the chance to pass new legislation to avoid a disaster in its own territory.
Vulture hedge funds’ predatory behavior is bad for individual countries but ultimately, it also threatens the entire global financial system. To improve the workings of globalization, the international financial architecture needs new rules. In 2014, the United Nations took the lead for pushing reforms, but the US and the UK, the two largest lending jurisdictions, did not support the process. For the good health of the global economy, it’s time for advanced nations to join efforts with the less developed ones, and work seriously on rules that work for everyone—not just for the vultures.