Vulture Funds in the Context of a Globalized Financial System

13 February by Daniel Munevar

The recent legal victory of a small group of vulture funds Vulture funds
Vulture fund
Investment funds who buy, on the secondary markets and at a significant discount, bonds once emitted by countries that are having repayment difficulties, from investors who prefer to cut their losses and take what price they can get in order to unload the risk from their books. The Vulture Funds then pursue the issuing country for the full amount of the debt they have purchased, not hesitating to seek decisions before, usually, British or US courts where the law is favourable to creditors.
over Argentina in the battle over its sovereign debt Sovereign debt Government debts or debts guaranteed by the government. has renewed the discussion regarding the role of these funds. Indeed, the decision of a US Court of forcing Argentina to pay its creditors based on an interpretation of an obscure clause has sparked fears regarding the vulnerability of other countries to the aggressive legal strategies employed by vulture funds. The main preoccupation is that even though they represent a relatively small group of firms, mostly based in tax heavens and financial centers like NY and London, their capacity to inflict economic damage on countries struggling with debt can be quite significant. They do so by causing delays and imposing additional costs in a process of sovereign debt restructuring as they force countries to pay debts in full. As a result, countries are usually forced to cut expenditures that are meant to guarantee the basic human rights of their population.

Given this context, the logical question is how comes not more attention has been devoted to understand and prevent the actions of these funds? Part of the answer is that the actions and impact of vulture funds Vulture funds
Vulture fund
Investment funds who buy, on the secondary markets and at a significant discount, bonds once emitted by countries that are having repayment difficulties, from investors who prefer to cut their losses and take what price they can get in order to unload the risk from their books. The Vulture Funds then pursue the issuing country for the full amount of the debt they have purchased, not hesitating to seek decisions before, usually, British or US courts where the law is favourable to creditors.
have grown in parallel to the expansion of the international financial system over the last 3 decades. As such, they represent a fairly new development. Until the 1970s, most of the developing countries satisfied their external funding needs through multilateral lending or bilateral loans with either governments or large banks. The presence of a small number of creditors using standard contracts limited the scope for litigation. However, as international financial flows were deregulated, the landscape of sovereign funding changed drastically. Instead of meeting their funding requirements through a loan from a large international bank, countries began to issue bonds that could be bought by thousands of investors. Thus, as countries began to increase their interconnection with global financial markets, this opened the door for the actions of vulture funds. Unlike a traditional investor that buys a security in order to obtain a stable and relatively small return, vulture funds were now able to target bonds of countries experiencing financial problems with the explicit objective of earning exorbitant returns through litigation. As bond Bond A bond is a stake in a debt issued by a company or governmental body. The holder of the bond, the creditor, is entitled to interest and reimbursement of the principal. If the company is listed, the holder can also sell the bond on a stock-exchange. issuance increased so did the actions of vulture funds. For example, a recent survey on the action of these funds, estimates that of all the litigation cases on sovereign debt Sovereign debt Government debts or debts guaranteed by the government. since 1970, 42.5% took place in the 1990’s and 45.8% in the 2000’s. In addition, the survey highlights the concentrated nature of their operation and targeting: 52% of the litigation cases was brought forward by funds, using US jurisdiction (85% of the total), against countries in Latin America (65.8%) and Africa (22.5%). |1|

Furthermore, the increase in the cases of litigation brought forward by vulture funds against developing countries was also made possible by changes in US legislation. Starting in 1976, legal protection for sovereigns issuing contracts under US law has been slowly undermined. The first step was the introduction of the US Immunities Sovereign Act. Under this new legal provision sovereign immunity does not automatically apply for commercial activities, such as external borrowing |2|. This was followed by a series of legal successes of banks and hedge funds Hedge funds Unlisted investment funds that exist for purposes of speculation and that seek high returns, make liberal use of derivatives, especially options, and frequently make use of leverage. The main hedge funds are independent of banks, although banks frequently have their own hedge funds. Hedge funds come under the category of shadow banking. over countries in Latin America in the context of debt crisis of the 1980’s. These “victories” set a precedent over the viability of a hold out and litigate strategy. These include the Allied vs Costa Rica case in 1982, Weltover vs Argentina in 1992 and CIBC vs Banco Central do Brazil in 1994 |3|. In each of these cases, US Courts systematically undermined the capacity of countries to claim sovereign immunity in order to protect themselves from the action of vulture funds. A new blow to sovereign immunity was dealt when a court ruling on the Elliot vs. Peru case eliminated the Champerty defense |4|. This doctrine prohibits, as a violation of the principle of good faith, the purchase of debt with the intent and purpose of bringing a lawsuit. After being severely weakened by several judgments, the final elimination of the doctrine came about in 2004 when a NY Court deemed that it was no longer valid for debts above USD 500.000 |5|. Taken together, alongside the recent NML vs Argentina case, it has become crystal clear that in case of doubt US courts will always side with vulture funds against sovereigns.

Given this trend, then why countries continue to issue debt under NY or UK law even if they are aware of the erosion of legal protection available to them, which borders on a renounce of their sovereignty? After all it is estimated that sovereign bonds issued under NY law and UK law represent respectively 48% and 40% of the total stock of outstanding international sovereign bonds |6|. The reason for this is a combination of limitations of domestic financial markets with short-term sightedness and lack of sophistication. In the case of the first issue, the low level of development of domestic financial markets means that countries are usually unable to issue long-term bonds. Thus, even if a country were to search for stable funding for 10 or more years the only option available would be to search for that funding in international markets, and as a result to submit itself to foreign law. In the second case, the cost of funding of external debt denominated under foreign law tends to be on average less than its equivalent in domestic debt |7|. As a result countries concerned with lowering the cost of their debt service Debt service The sum of the interests and the amortization of the capital borrowed. today might prefer to issue debt under foreign law. The problem with this approach is that in the event of default, contracts under domestic law can be amended to ensure the protection of the country while providing fair treatment to investors. In the case of contracts under foreign law, countries are left exposed to the actions of vulture funds. Thus, what might be considered cheap and viable today usually proves to be extremely costly in the future.

To make matters worse, policy makers in developing countries might not even be aware of the existence of such trade off. Low income countries that issue bonds in order to replace multilateral or bilateral official lending most likely lack the sophistication required to deal with the intricacies of contracts issued under sovereign law. Even though there has been a significant effort to ensure that debt contracts include Collective Auction Clauses (CAC), a mechanism to limit the capacity of vulture funds to disrupt sovereign debt restructurings, the exposure of low-income countries is still quite significant. On the one hand, it is estimated that of a total of USD 1.032 trillions of outstanding sovereign debt bonds, only 18% contains enhanced CACs, which provide up to date protection against the known strategies of vulture funds |8|. On the other, changing patterns in the structure of funding are increasing the number of countries at risk. For example, in the case of countries in the Sub Sahara region, the increase in issuance of external debt that has taken place over the last decade has left them exposed to significant macroeconomic risk |9|. A materialization of those risks could spark a wave of defaults that would render these countries vulnerable to the action of vulture funds.

This brief overview clearly shows that the action of vulture funds, rather than an accidental effect, is a direct consequence of financial globalization. Not unlike low income households in the US that were scammed by large banks in the subprime bubble, so are countries left to deal with the actions of unscrupulous investors targeting those less able to defend themselves. As in the case of any complex problem, the solutions to this issue are not simple. Besides the need for a multilateral debt restructuring mechanism to protect countries from the actions of vulture funds, such as the one called for by the UN in 2015, countries should implement legal measures at the national level to deter the actions of funds. A good example of this approach is the law approved in Belgium in 2015 against vulture funds. The potential effectiveness of this method is reflected on the counter measures taken by notorious vulture fund NML capital, which is currently trying to undermine the law by appealing to the Belgian Constitutional Court. CADTM is currently participating in this legal process so as to ensure the law remains in place |10|.

Last but not least, its also important that countries recognize that the path to development and better living standards for their population does not go through debt. Thus, as important as the efforts to establish a debt restructuring mechanism are, its equally vital to promote a more fair trading Market activities
trading
Buying and selling of financial instruments such as shares, futures, derivatives, options, and warrants conducted in the hope of making a short-term profit.
and economic system that allows countries to earn their own development.


International Call to Support and Internationalize the Belgian Law on Vulture Funds


Footnotes

|1| Schumacher, J., Trebesch, C., & Enderlein, H. (2012). Sovereign Defaults in Court: The Rise of Creditor Litigation 1976-2010. SSRN Electronic Journal. http://doi.org/10.2139/ssrn.2189997

|2| UNCTAD. (2016). Sovereign Debt Restructurings: Lessons learned from legislative steps taken by certain countries and other appropriate action to reduce the vulnerability of sovereigns to holdout creditors. Retrieved from http://www.un.org/en/ga/second/71/s...

|3| Schumacher, J., Trebesch, C., & Enderlein, H. (2012). Sovereign Defaults in Court: The Rise of Creditor Litigation 1976-2010. SSRN Electronic Journal. http://doi.org/10.2139/ssrn.2189997

|4| ELLIOTT ASSOCIATES, L.P. v. THE REPUBLIC OF PERU | 961 F.Supp. 83 (1997). (1997). Retrieved February 10, 2017, from http://www.leagle.com/decision/1997... ASSOCIATES, L.P. v. THE REPUBLIC OF PERU

|5| Guzman, M., & Stiglitz, J. (2015). Fixing Sovereign Debt Restructuring. Retrieved from http://www8.gsb.columbia.edu/facult... Fixing Sovereign Debt Restructuring.pdf

|6| IMF. (2014). Strengthening the Contractual Framework to Address Collective Action Problems in Sovereign Debt Restructuring. Retrieved from https://www.imf.org/external/np/pp/...

|7| Carletti, E., Colla, P., Gulati, M., & Ongena, S. (2016). Pricing contract terms in a crisis: Venezuelan bonds in 2016. http://doi.org/10.1093/cmlj/kmw022

|8| IMF. (2016). SECOND PROGRESS REPORT ON INCLUSION OF ENHANCED CONTRACTUAL PROVISIONS IN INTERNATIONAL SOVEREIGN BOND CONTRACTS. Retrieved from http://www.imf.org/external/pp/ppin...

|9| Gevorkyan, A. V., & Kvangraven, I. H. (2016). Assessing Recent Determinants of Borrowing Costs in Sub-Saharan Africa. Review of Development Economics, 20(4), 721–738. http://doi.org/10.1111/rode.12195

|10| CADTM. (2016). CADTM - Belgian legislation against vulture funds should be preserved – UN rights expert urges. Retrieved February 10, 2017, from http://www.cadtm.org/Belgian-legisl...

Author

Daniel Munevar

is a 30-year-old post-Keynesian economist from Bogotá, Colombia. MPAff. LBJ School of Public Affairs at the University of Texas at Austin. From March to July 2015 he worked as a close aide to former Greek finance minister Yanis Varoufakis, advising him on issues of fiscal policy and debt sustainability. He was previously fiscal advisor to the Ministry of Finance of Colombia and special advisor on Foreign Direct Investment for the Ministry of Foreign Affairs of Ecuador. He is considered to be one of the foremost figures in the study of Latin American public debt. He is member of CADTM AYNA.


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