Insight - Sovereign issuers seek to thwart Argentina-style attacks by funds

By Daniel Bases

NEW YORK (Reuters) - Government bond issuers are adopting new standards intended to thwart a strategy that's plagued Argentina for 13 years, in which buyers snap up distressed debt for pennies on the dollar and then hold out for full payment after other investors have agreed to restructure.

Since August, as many as 12 of 22 recent emerging market issuers including Kazakhstan and Mexico have inserted language in their bond prospectuses that makes it prohibitively expensive for a single holdout to block a restructuring settlement that the majority of creditors may have accepted. This week Ecuador, which defaulted in 2009, issued new bonds that incorporate the language, developed by the International Capital Markets Association.

Driving the move to change is the situation in Argentina, lawyers and bankers said. After Argentina sought to refinance almost $100 billion (67 billion pounds) in debt and gained the agreement of 93 percent of the holders, investors led by Elliot Management and Aurelius Capital Management rejected the restructurings and demanded full payment. Argentina responded by calling the holdouts "vultures" and refused to pay.

The new mechanism being adopted, known as the aggregated collective action clause (CAC), is aimed at preventing future implementation of the Elliot and Aurelius playbook.

"The new CACs crush the business model of holdouts," said Gregory Makoff, a senior fellow at Centre for International Governance Innovation in Waterloo, Ontario.

"Holdouts thrive on buying small amounts of bonds that can't be forced into a transaction," said Makoff, who's based in New York and formerly advised nations including Jamaica, South Africa and the Philippines on debt transactions during a career at Citigroup. "Now there is nowhere to hide since a supermajority can now sweep all bondholders into a transaction."

To be sure, it may take decades for the holdout business model to completely wither away as old-style bonds mature, since the new language applies only to newly issued bonds. Trying to retrofit such language onto old bond covenants would be cumbersome and costly, lawyers said.

Both Elliot and Aurelius declined to comment on the new standards. Holdouts have argued that they play an important role in the credit markets by offering liquidity during distressed times. The new standards diminish their incentive to hold out on a deal.

In a nutshell, an aggregated CAC means all of a sovereign's bondholders' votes in a restructuring are counted in a single pool and if it passes the results are binding on all the bonds. That means if the supermajority of those votes agrees to a deal, then even those who don't like the terms have no choice but to accept them.

"Neither the sell-side, meaning the issuers, nor the hard money buy-side likes the result in Argentina," said Antonia Stolper, a sovereign securities lawyer at Shearman & Sterling in New York. "For them it is a practical matter."

Stolper said adoption of the new language by sovereign issuers for their international bonds, typically adapted to either English or New York courts, has been "spectacularly fast."

JUDGE GRIESA

The new covenants also include language written specifically to counteract the disputed opinion of U.S. District Judge Thomas Griesa in Manhattan. His view of the so-called pari passu clause, or equal treatment clause, is what the holdout hedge funds have used to win $1.33 billion plus accrued interest.

"The modification to the pari passu clause diminishes investors' ability to litigate," said Moody's Investors Service analyst Elena Duggar, who on March 13 published a study on the new language.

Griesa's opinion has been upheld on appeal and Argentina has exhausted its legal recourses. Until Argentina agrees to a settlement with the holdouts, its ability to reenter the international capital markets is severely restricted at a time when its shaky economy needs fresh investment.

In October 2014 Kazakhstan adopted the new English law versions nearly verbatim, while Mexico led the way for bonds governed by New York law with an issue in November.

A simpler form of sovereign CACs were first used by Mexico in 2003, a milestone in the sovereign debt investment community. Those bonds matured earlier in this month.

In fact, it was the Mexican peso crisis in December 1994 and subsequent international bailout that launched an effort to design bond covenants that would lessen the burden on the official sector and shift it to private bondholders.

Belgian deputy central bank governor Jean-Jacques Rey headed a report issued to the G10 in 1996 that laid the groundwork for changes while the Argentine default in 2002 accelerated the effort to Mexico's historic move in February 2003.

"It took about eight years for the initial CACs to go from the drawing board to the marketplace. The new CACs made the leap in less than two years - record speed in the arcane world of sovereign bond documentation," said Makoff.

RATINGS AND PRICES

Still, while the adoption of the new language has been fast, its effect on ratings, a key element on the pricing of deals, has been nil.

"From a credit point of view, we don't think it will make a material impact on ratings. That decision is driven by the ability to pay," said Moody's Duggar.

A unresolved question in the event of a default is over which equal treatment covenant will take precedent, as the new ICMA-inspired pari passu clause is considered weaker in its protection of creditors than the existing clause underpinning the holdouts case against Argentina, Duggar said.

When CACs were introduced by Mexico in 2003 the effect on market prices was negligible, say veteran bankers. That remains the case.

"Regarding CACs, I don't think new issue bond pricing has been materially impacted by the inclusion of the new language to date," Clayton Pope, head of emerging market bond syndicate at Credit Suisse in New York, told Reuters.

(Reporting by Daniel Bases. Editing by David Gaffen and John Pickering)