Second Circuit Construes Pari Passu Clause in Argentine Bond Issuance (But the Saga Continues)

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Contributed by Yvanna Custodio

The decision issued by the United States Court of Appeals for the Second Circuit in NML Capital, Ltd. v. Republic of Argentina sheds light on the meaning and application of pari passu clauses in sovereign bond issuances.  In NML, the Second Circuit held that an equal treatment provision barred Argentina from discriminating against plaintiffs’ bonds in favor of bonds issued pursuant to Argentina’s 2005 and 2010 restructurings and enjoined Argentina from making payments on the new bonds without also making payments on plaintiffs’ old bonds.

The ten-year litigation dates back to the year 1994, when Argentina began issuing debt securities pursuant to a Fiscal Agency Agreement, known as FAA bonds.  The plaintiffs began buying these bonds in 1998 (some FAA bonds were purchased in the secondary market as recently as 2010).  The pari passu clause at issue purportedly protected purchasers of the bonds from subordination.  The clause provided that the

Securities will constitute . . . direct unconditional, unsecured and unsubordinated obligations of the Republic and shall at all times rank pari passu without any preference among themselves.  The payment obligations of the Republic under the Securities shall at all times rank at least equally with all its other present and future unsecured and unsubordinated External Indebtedness . . . .

The Second Circuit referred to the second sentence of the pari passu clause as the “Equal Treatment Provision.”

In December 2001 and every year thereafter, Argentina put in effect a moratorium on principal and interest payments on approximately $80 billion of public external debt, which included the FAA bonds.  After Argentina’s default on the FAA bonds, the country offered the FAA bondholders new exchange bonds in 2005 and 2010 and continued to pay holders of the exchange bonds, but withheld payment to holders of the FAA bonds.  The prospectus of each exchange offer contained similar provisions on the risks of failing to participate, including that defaulted bonds eligible for exchange but which remained untendered would be in default indefinitely.  The Argentine legislature also passed the Lock Law in 2005, adding pressure on the FAA bondholders to accept the exchange offer.  The Lock Law declared, among other things, that Argentina “shall be prohibited from conducting any type of in-court, out-of-court or private settlement with respect to the bonds . . . .”  When Argentina initiated its second exchange offer in 2010, it temporarily suspended the Lock Law because the law contained a prohibition against reopening the exchange.

Given that New York law governed the Fiscal Agency Agreement pursuant to which the FAA bonds were issued and that the FAA provided for jurisdiction in “any state or federal court in The City of New York[,]” the plaintiffs sued Argentina in the United States District Court for the Southern District of New York, alleging breach of contract and seeking injunctive relief.  The plaintiffs argued that Argentina had violated the pari passu clause by subordinating their FAA bonds (estimated at approximately $1.33 billion, including unpaid principal and prejudgment interest) and lowering the ranking of the FAA bonds below the exchange bonds.  In December 2011, the district court granted the plaintiffs partial summary judgment and noted that Argentina violated the Equal Treatment Provision by lowering “the rank of its payment obligations under [plaintiffs’] Bonds below that of any other present or future unsecured and unsubordinated External Indebtedness.”  The district court held that Argentina lowered the rank of the FAA bonds by making payments under the exchange bonds, but refusing to do so under the FAA bonds, as well as by enacting the Lock Law and the Lock Law Suspension.

Second Circuit Holds Argentina Violated the Pari Passu Clause

On appeal, Argentina asserted several reasons why the district court erred, including that the pari passu clause has a universally accepted meaning that protects against “legal subordination or other discriminatory legal ranking by preventing the creation of legal priorities by the sovereign in favor of creditors holding particular classes of debt.”  The Second Circuit observed, however, that in the context of sovereign debt, the interpretation Argentina advanced was “neither well settled nor uniformly acted upon[]” and ultimately, the dispute revolved around the meaning of subordination under the pari passu clause.  Argentina argued that the clause only guards against legal subordination, which did not occur because claims arising from Argentina’s restructured debt would have no priority “in any court of law” over claims arising out of the country’s unrestructured debt.  The plaintiffs argued, in contrast, that the FAA bonds were de facto subordinated when Argentina passed legislation barring payments on the bonds, thereby lowering their ranking to “a permanent non-performing status.”

Employing principles of contract construction, the Second Circuit disagreed with Argentina’s interpretation because it failed to give effect to the two sentences of the pari passu clause:  By pairing the two sentences in the clause together, the FAA demonstrated the intention to protect bondholders from more than formal subordination.  The first sentence prohibited discrimination through the issuance of superior debt and the second sentence prohibited discrimination through the giving of priority to other payment obligations.  The Second Circuit observed that the second sentence safeguarded against discrimination in the sovereign debt context because no international bankruptcy proceeding exists for sovereign countries and no universal statute exists for governing the priority of creditors.  Rather, in the sovereign debt context such as Argentina’s case, “the Equal Treatment Provision prevents Argentina as payor from discriminating against the FAA bonds in favor of other unsubordinated, foreign bonds.”  Thus, the Second Circuit concluded that Argentina discriminated against the plaintiffs’ bonds.

The Saga Continues

Although the Second Circuit affirmed the decision of the district court, it remanded the case to the district court seeking clarification on how the injunction’s payment formula were to function as well as the application of the injunctions to third parties such as intermediary banks.  The Second Circuit also ruled that once the district court proceedings were concluded, “the mandate should automatically return to [the Second Circuit panel] for further consideration of the merits of the remedy without need for a new notice of appeal.”  On November 21, 2012, the district court clarified that Argentina would be required to pay the amount of the unpaid principal and accrued interest totaling approximately $1.33 billion to the plaintiffs.  In discussing the scope of the injunction and its application to third parties, the district court observed that, under Rule 65(d) of the Federal Rules of Civil Procedure, an injunction binds the parties, their agents, and persons “in active concert or participation” with the parties or their agents.  The district court agreed with the plaintiffs’ contention that the injunctions should bind Argentina, the indenture trustee, the registered owners, and the clearing system, but that a carveout for intermediary banks was appropriate.  On November 27, 2012, Argentina sought a stay of the district court’s November 21 orders pending further appellate review.  Holders of the exchange bonds also filed an emergency motion for leave to appear as interested non-parties and for a stay pending appeal of the district court’s injunction.  On November 28, 2012, in separate orders, the Second Circuit granted the exchange bondholders’ motion for leave to intervene as well as stayed the district court’s November 21 orders.  Further, the Second Circuit expedited the briefing schedule of the appeal from the district court’s orders.  Recently, the Second Circuit denied the plaintiffs’ request for an amendment of the November 28 stay order, which would have required Argentina to post security in order to maintain the stay.  Oral argument for the appeal from the district court’s orders is scheduled on February 27, 2013.