In the early 2000s, many countries experienced yet another debt crisis. Argentina was particularly vulnerable, having already defaulted more than a half dozen times on the debt it owed to banks and other financial institutions. Despite the confidence of its creditors, the International Monetary Fund (IMF) and the U.S.Treasury Department, negotiations broke down around the restructuring of Argentina’s debt. The ensuing litigation led to a crippling depression and culminated in another default in 2014.
The Argentine Ministry of Finance at this time came up with an innovative way to deal with this latest debt default. In exchange for a deep reduction on the $100 billion that it owed, Argentina agreed to pay creditors a discounted amount if its GDP grew by a certain amount. But some creditors, approximately 7 percent, held out for full repayment.
The state of New York, where many of the holdout creditors operated, ruled in favor of these investors. Hedge funds which had bought Argentine debt at a discount for millions of dollars ended up, after litigation, making billions of dollars. As a result of such hard-ball legal tactics, these hedge funds acquired a reputation as “vulture funds.”
The Model Law
The excessive profits made by these funds have become even more controversial in light of recent events. During the height of the COVID pandemic, the IMF and the World Bank tried, with their Debt Service Suspension Initiative (DSSI), to provide a respite, but that facility has ended and many countries are now facing a high inflation environment fueled by a war in Ukraine and climate change. The Common Framework program, available to the poorest countries, has not proven successful. In addition, China has become a significant lender to low- and middle-income countries, and it is not aligned with the international system. Unlike in the past, when mostly banks provided financing, sovereign debt has increasingly been purchased by large investors, both institutional and speculators.
To rein in the exorbitant profits that such funds have made off of the sovereign debt of countries like Argentina, a coalition of civil society organizations have worked with policymakers to craft a Model Law for Sovereign Debt in New York State. Often referred to as “the model law,” this legislation provides a statutory pathway to debt restructuring for sovereign bonds in default, similar to a contractual mechanism called a collective action clause (CAC) or enhanced CACs that are in some bond contracts. In addition, the model law is retroactive, allowing countries and creditors to use it regardless of when the bond was issued. The model law would create a Chapter 11-like process for countries. According to existing New York state law, it would apply to about half of the sovereign bonds issued by countries. The other half, issued in Great Britain, falls under UK law.
The proposed New York bill can be used in multiple jurisdictions. The package of bills includes an update of champerty, a law stretching back 100 years, that prohibited an unrelated party from mounting a suit, which was weakened in 2004 at the behest of the hedge fund industry.
As the Argentina case illustrates, there is no orderly and timely process for a country in default to negotiate a restructuring with creditors that is transparent and provides a degree of certainty for both debtor and creditor. This leaves countries at risk, particularly to speculators. When the initial creditors go to sell bonds for a loss, these bad-faith creditors purchase debt cheaply on the secondary market and then wait while they insist on being paid the full amount, even when the majority of creditors agree to a plan that forgives a portion of the amount owed for the sake of being paid. This is a growing aspect of the sovereign debt market in general. According to a European Central Bank report,
In recent years, 50% of debt crises involved litigation, compared to less than 10% in the 1980s and early 1990s. The claims under dispute have grown notably, from close to zero in the 1980s to an average of 3% of restructured debt, or 1.5% of debtor country GDP in the 2000s.
Learning from Puerto Rico
For New York Communities for Change (NYCC), the bond market was not a real concern until its members from the Puerto Rican diaspora made it so. The servicing of an over $70 billion debt meant the island struggled to keep schools and hospitals open and couldn’t make much-needed payments to pensioners. In the New York diaspora, families were highly aware of the problems faced by their kin.
The legislation to rein in vulture funds developed by NYCC, based on Duke University Professor Steven Schwarcz’s paper “Sovereign Debt Restructuring: A Model-Law Approach,” was a discovery for those involved in the Puerto Rico campaign. The proposed New York state legislation would broaden the options for countries to address their debt burdens while also strengthening the existing financial system for the secondary sovereign bond market.
Immigrants from Latin America are well aware of what debt means for their countries. It was fairly easy for NYCC to sell the campaign to members normally accustomed to tackling bread-and-butter issues like housing, school funding, and better wages and working conditions. In 2020, NYCC researchers worked with Schwarcz to draft the legislation. They met with dozens of experts including Yanis Varoufakis, Joseph Stiglitz, and Lee Buchheit. After introducing the legislation in 2021, the coalition has educated members of the New York state legislature, held several public events, generated some media attention, and garnered the attention of white shoe law firms that represent both countries and creditors. The group has also met with the official sector and some investor groups, and is currently helping another coalition to introduce its own legislation.
These state-level efforts are gaining momentum because, unlike international and some national initiatives, they are more feasible politically. Moreover, the model law creates a restructuring opportunity because it is a voluntary mechanism, eliminating political barriers. A country would petition to use the mechanism and good faith creditors would willingly take part. It would allow the country to maintain its short-term debt by having access to the capital markets and prevent bad faith actors from blocking the entire restructuring through the use of supermajority voting by creditors. This would allow a country to bring down its debt burden to a manageable and sustainable level.
New York and London have highly developed economies that appeal to both creditors and countries who recognize their long histories of case law and respect for contracts. Because of its multijurisdictional component, the model law could cover both of these major markets. As IMF Managing Director Kristalina Georgieva has said, “We also are pressing for some legal changes that need to happen in New York, in London, to close loopholes for vulture funds and others to prevent debt resolution.”
It’s time to make sure that what happened to Puerto Rico and Argentina—and so many other places struggling with debt repayment—never happens again.