I spent all of yesterday at a fascinating and wonky conference in London, on the economics and law of sovereign debt. I gave a short talk on the latest developments in Elliott vs Argentina (a/k/a NML vs Argentina), and specifically on the decision which was handed down by the Second Circuit court of appeals on August 23. These are the notes I drew up for the talk.
And now abide faith, hope, love, these three; but the greatest of these is love.
We've all heard these words at weddings, and even sometimes at funerals. But I've written my own version, just for pari passu geeks. It goes something like this:
And now abide secured, unsecured, judgments, these three; but the greatest of these is a judgment.
I am not a lawyer. But maybe because I'm not a lawyer, I feel like I can look at what's going on in the NML vs Argentina case from a little bit of a distance. And when I do that, what I see is a series of court decisions which have undermined the very way in which debt is understood to work.
Remember that pari passu, at heart, is all about ranking; it's about seniority of payment. And the way I see it, seniority works in a pretty well-established way. First of all, there's unsecured debt. Mitu lends me money, and now I owe him a certain sum on a certain date. It's pretty simple. If I pay him, he's happy; if I don't pay him, he's sad.
Next up, there's secured debt. Henrik lends me money, but he's worried that I might not be able to pay him back. So he insists on a lien: he wants me to put up my country house as collateral. As with Mitu, I still owe Henrik a certain sum on a certain date. And as with Mitu, if I pay him, he's happy. But if I don't pay him, he goes straight to plan B: he seizes my country house, sells it, and uses the proceeds to ensure that he's repaid in full. Still, Henrik can still end up unhappy. If I don't pay him, and if my country house has burned down, then there's nothing to seize, and he ends up where Mitu was, holding a defaulted obligation.
This is where the courts come in. Once I'm in default, any of my creditors - Mitu, Henrik, Joseph, it doesn't matter - can go along to a court and reduce their obligation to a judgment. And judgments are very powerful things. Because once you're armed with a judgment, you basically become an ultra-secured creditor. If I own a country house, you can forcibly attach that, and sell it, and pay yourself from the proceeds. But if my country house has burned down, you can attach any of my other possessions instead - you can attach my stock portfolio, or my wine cellar, or even, most simply, my bank account. Anything I own, if it can be reached by the long arm of the law, is now within your grasp.
There are only two ways for me to foil you, if I have assets and you have a judgment. The first is for me to declare bankruptcy. But for the sake of argument, let's say that bankruptcy isn't an option. Maybe my assets vastly exceed my liabilities. The second is for me to somehow move my assets to where they can't be touched by your courts. Maybe I smuggle my stamp collection into a safety deposit box in Iran. It's not going to do you much good there, because your judicial system isn't going to be able to extract it from that box and sell it.
Still, even if you have a judgment, you can't attach what isn't mine. For instance, let's say that Joseph has a bank account. If I owe Mitu money, even if he's armed with a judgment, he can't barge in and attach Joseph's bank account. Just mine.
Now it's true that I borrowed money from Mitu and from Henrik, and that I defaulted on both of those loans. I borrowed money from Joseph, as well. Joseph has something weird - he has something called subordinated debt. In his loan documentation, it explicitly says: "I will not pay you any money unless and until I've paid Mitu first. Mitu is senior, and you, Joseph, are junior."
So when I default on my obligation to Mitu, Joseph is also sad: he knows that he's junior to Mitu, which means that I'm not going to be paying my subordinated creditors any time soon.
But when Joseph's coupon date rolls around, guess what? I walk into his bank, take out a wad of cash, and tell the bank to deposit into Joseph's account every penny that he's owed. Now, Joseph is happy: he's just received an unexpected windfall. And Mitu is furious, because he knows what I promised Joseph.
Mitu has been patient with me, so far, but now his patience has run out, and finally he decides to go to court. "I have a piece of paper here which clearly says that I'm a senior creditor," he tells the judge. "And Felix is going and paying his junior creditors, without paying me!"
The judge is sympathetic, and wants to help out Mitu in any way he can. "I'll tell you what," he says. "I'll give you a judgment, that's what judges do. And then, armed with that judgment, you can attach anything that Felix owns, and use those assets to pay yourself everything you're owed." This mollifies Mitu, because he knows that judgments are the best thing you can have. But it takes time to locate and attach assets, and when Joseph's next coupon date rolls around, I go and do exactly the same thing: I walk into Joseph's bank, and tell them to deposit a bunch of money into Joseph's account.
Now Mitu is really hopping mad, and he goes back to the judge, who is still sympathetic. But then Mitu goes too far. He asks the judge to bring down a judgment not on me, but rather on Joseph. "Tell Joseph that he owes me the money," says Mitu. The judge is a bit puzzled. "Does Joseph owe you money?" he asks. "Where do you have a contract with Joseph?"
"Oh," says Mitu. "Good point. I don't have a contract with Joseph, I only have a contract with Felix. So you can't tell Joseph that he owes me money. But hang on, I have another idea. I can see what Felix is doing now: he's paying Joseph, without paying me. So I want you to go to Joseph's bank, and tell them that the next time Felix deposits money into Joseph's account, they should refuse to do that."
Now the judge is really puzzled. "Joseph's bank?" he says. What have they got to do with anything? They're just the institution which looks after Joseph's money. And in fact, they have a very clear contract of their own, with Joseph, and they don't have any kind of contract with you. Felix promised to pay you money, and he broke that promise, and I've given you a powerful judgment saying that Felix owes you money. But neither Joseph nor Joseph's bank owes you money, so I'm not going to start slapping injunctions on them."
Mitu is unimpressed. "But Felix promised that he wouldn't pay Joseph without having paid me first!" The judge, on the other hand, is equally unimpressed. "Yes, Felix broke his promise. Felix broke his promise the minute that he defaulted on his payment obligation to you. He has since broken another promise. And he can go head and break a thousand more. When Felix breaks his promise, I enter a judgment against Felix. I've done that. But I'm not going to start handing down judgments on Joseph, or on Joseph's bank, just because Felix has broken a promise. Those guys are independent actors, and have no control over what Felix does. So leave them alone."
Most of the time, this story works out quite well for Mitu. Because my assets exceed my liabilities, and because Mitu has a judgment against me, it's not hard for him to get satisfaction. But regardless of whether Mitu ends up being satisfied or not, the principle is clear. The remedy, if I break my contractual promise, is that my creditor can get a judgment against me. And a judgment is to all intents and purposes the most senior claim that anybody can have.
This is why I find the behavior of the judges in New York to be so bizarre. Firstly, they have turned the natural order of creditors on its head. Secured, unsecured, judgments, these three; now the greatest of these is, bizarrely, unsecured, with a pari passu clause. It's the unsecured creditors who are being able to get remedies which - at least so far - have proven unavailable to either secured creditors or judgment creditors.
Secondly, there's no real logic to how this new system of jurisprudence should be enforced. It seems to me that if Joseph has explicitly subordinated debt, and Mitu goes to court, then Mitu is going to come away empty-handed, because the explicit subordination is in Joseph's bond documentation rather than in Mitu's. But if Mitu manages to find the right flavor of pari passu clause in his own documentation, then suddenly everything changes, and the nuclear remedy becomes magically available.
Thirdly, the judges have created a new class of activity, for debtors, which is Worse Than Default. It used to be that when it came to debt contracts, defaulting was the worst thing you could do. That's no longer the case: now, the worst thing you can do is to selectively default. In other words, if I pay Joseph and don't pay Mitu, that's considered worse than if I don't pay Joseph and don't pay Mitu. Because only in the first case - only when I'm in partial default - will New York's judges roll out their brand-new thermonuclear remedy.
Fourthly, it is now entirely acceptable, under New York's system of jurisprudence, for judges to punish the innocent, rather than the guilty. Neither Bank of New York nor the exchange bondholders have done anything wrong. All they're doing is collecting the money they are rightfully owed. But if these rulings stand, they won't be allowed to do that any more.
This is the bit which annoys me most about the Second Circuit's ruling. The courts are clearly punishing the innocent, with these rulings, and yet are bending over backwards to pretend that they're not. If you're going to do something as unintuitive as this - if you're going to make unsecured non-judgment creditors effectively the most senior, and create a brand-new nuclear remedy, and punish the innocent, and violate a whole bunch of sovereign-immunity precedent while doing so - then at the very least you should be open and honest about what you're doing and why you're doing it.
Instead, the rulings of both Judge Griesa and the Second Circuit are run through with pinched and disingenuous legal reasoning. They refuse to step back and take responsibility for the big-picture consequences of their actions, and it's that, to me, which is by far the worst thing they've done. I have precious little sympathy for Argentina, in this case, and not much for Elliott Associates either - but at least both of them are openly and honestly making the best case they possibly can for their actions. The New York courts, by contrast, are just being poltroons, and it's their ignoble cowardice which really drives me up the wall and which is the main reason the Supreme Court should accept this case and decide it head on.
I can understand the pique and frustration which led Judge Griesa to enter his original judgment against Argentina. When an actor in your court is being as consistently and unapologetically contumacious as Argentina, eventually you reach breaking point. But when that kind of thing happens, it's the job of the appeals court to provide cooler heads, and to say hang on a minute, what are we doing here, are we sure we really want to go down this road. Especially when you're the court which has for decades looked after the New York payments system and the US financial architecture.
But that's not what the Second Circuit did. Instead, they ducked all the big questions, and decided this case as narrowly and pedantically as they conceivably could. Which is why they - much more than Elliott Associates, or Argentina, or anybody else - are the biggest villains of this story. Of all the actors on stage, it's the Second Circuit which has acted in the worst faith. I hope - against hope - that the Supreme Court will hold them to account for their actions.