In Defense of Elliott v. Peru
When I was in high school, my dad told me about a hedge fund named Elliott and the 15-year legal masterpiece that involved the seizing of an Argentine naval vessel. Since then, I’ve read everything there is to read about the Elliott-Argentina investment, including a fantastically detailed book published in 2024 titled “Default” by Gregory Makoff. I recently finished the aforementioned book, and it is only now, almost a decade later, that I realized that the Argentina investment was not the blueprint but was, in fact, strategically primed by a prior sovereign investment in Peru. The wizards at Elliott had managed to take what was a harmless and standard inclusion in most sovereign documents and wield it like a financial longsword (which is, of course, what Elliott does best). The culprit is the pari passu clause. Most credit professionals will recognize this Latin word as the building block of modern-day credit structures; however, in the case of Elliott v. Peru, the interpretation of the pari passu clause was not as developed as it is today and allowed Elliott to set a precedent that would bleed over to the larger and more publicized Argentine debt restructuring.
More importantly to modern credit investors, particularly those involved in U.S. corporate credits, a similar interpretation would form in the post-pandemic era of restructuring, namely through liability management exercises. The purpose of this paper is to answer two questions: i) what can we learn from Elliott v. Peru, and ii) is this interpretation analogous to the corporate interpretation of pari passu?
Background
In 1996, Elliott made five trades to purchase $20.7 million of Peruvian sovereign bonds, issued by Banco de la Nación and Banco Popular del Perú, at an average price of 55 cents on the dollar. Neither institution had made interest payments on the bonds and therefore was in default. Elliott, as part of its investment strategy, sued the Republic of Peru to recover on par plus accrued interest. The Republic of Peru, in response, countered that the purchase of the debt was invalid as Elliott had committed “champerty” (i.e., purchasing debt with the sole purpose of litigation). Judge Robert Sweet of the Southern District of New York ruled against Elliott; however, this decision was overturned on appeal, and Elliott was awarded a judgment of ~$55 million.
Upon moving to collect on their judgment, Elliott was faced with a Peruvian government at risk of defaulting on another tranche of bonds; an interest payment of ~$80 million was necessary to avoid a default. This interest payment was the focal point around which Elliott formed its attack. Why should the Peruvian government be allowed to make an interest payment to bondholders when there is an outstanding judgment against a pari lien of debt? In the first step of their “blitzkrieg,” as Makoff describes it, Elliott simultaneously filed restrictions in New York, England, Belgium, and Luxembourg to block the interest payments. This was done strategically as Chase Manhattan, the paying agent, had offices in both New York and London, and the payments had to be cleared in Belgium and Luxembourg. According to Makoff, “it was a clever strategy because Elliott needed to frustrate only a part of Peru’s payment to force the country into a corner. Missing even a portion of the amount due would be a default event, under the terms of the [bonds].”
Ultimately, the breakthrough came from Belgium. Roughly $40 million of interest payments were blocked, which, despite the 30-day grace period, forced the Peruvian government to come to the table. In the initial resolution, the Brussels Court of Appeals wrote,
“… the basic agreement regulating the reimbursement of the Peruvian foreign debt, also indicates that the different creditors enjoy a 'pari passu clause', which has as a result that the debt should be paid down equally towards all creditors in proportion to their claim.”
In the end, the Republic of Peru settled with Elliott for $58.5 million. However, the 411% return from the Peruvian investment was just setting the stage for what would be Elliott’s magnum opus.
Impact of the Ruling
Almost immediately (immediately being a relative term), the standard set in Elliott v. Peru was challenged through the 2001 Argentine restructuring. This time, Elliott held a much larger hold at around $632 million of Argentine bonds issued under the Fiscal Agency Agreement (FAA bonds). In 2005, Argentina had managed to exchange ~76% of its outstanding debt for around 30 cents on the dollar. However, unsurprisingly, Elliott, through a Cayman Islands entity known as NML Capital, Ltd., rejected the offer and cemented its status as the lead holdout creditor. In 2010, Argentina attempted to execute a second debt exchange, this time at a price of 35-38 cents on the dollar. Elliott once again refused the exchange and instead filed a complaint in the Southern District of New York (SDNY). The complaint sought to place an injunction on all consenting creditors’ payouts, citing that all creditors must be paid out ratably under the pari passu. As a result, the issue of pari passu was then brought to Judge Thomas Griesa of the District Court for SDNY, where the case was litigated until 2011.
In 2011, 10 years after Argentina’s initial default, Judge Griesa ruled in favor of Elliott, citing the same reasoning as Judge Sweet and granting the injunction. The U.S. Court of Appeals for the Second Circuit upheld the decision in 2012, issuing a scathing criticism of the Republic’s interpretation of the pari passu clause.
“The pari passu clause at issue provides that the Republic’s payment obligations ‘shall at all times rank at least equally with all its other present and future unsecured and unsubordinated External Indebtedness.’ The Republic’s payment obligations rank equally with other external indebtedness both in a formal sense and in a practical sense… In so doing, the Republic has breached its promise that the bonds ‘shall rank at least equally.’ The district court properly found that Argentina’s actions have resulted in the violation of the pari passu clause because they have rendered the Republic’s payment obligations subordinate in fact…The Republic contends that the pari passu clause merely prohibits it from formally subordinating the bonds to other indebtedness, for example, by enacting legislation that subordinates one debt to another. But such a reading ignores the practical effect of the Republic’s actions and would render the clause meaningless. The district court did not err in rejecting that interpretation.”
In 2014, Elliott settled with the Republic of Argentina for $2.4bn, almost 4x the value of the claim at filing and more than 20x what Elliott had paid for the bonds. Thus ended the 15-year-long Argentine debt restructuring. While infamous for its courtroom antics and repossessions of naval vessels, this otherwise anticlimactic legal battle had cemented pari passu as a practical and enforceable concept.
A Pandora’s box had just been opened.
Lien Priority vs. Payment Priority
The Brussels ruling, while appearing standard for any collection on a judgment, had unknowingly unified payment priority and lien priority. Prior to the ruling, the two priorities had been considered separate under the pari passu clause - in fact, payment priority was not even previously defined in sovereign debt restructurings. Philip R. Wood, renowned attorney in international finance, writes, “In the state context, the meaning of the clause is uncertain because there is no hierarchy of payment which is legally enforced under a bankruptcy regime.” It is for this reason that the Elliott v. Peru ruling was particularly scrutinized.
The key to understanding the criticism from legal scholars lies in the contractual difference between lien ranking and payment priority. Ranks were seen as buffers to prevent sovereigns from issuing new debt that is either pari passu to or primes the existing debt. On the other hand, payment priority demands simultaneous, pro-rata payments across all instruments in a rank, especially if the total pool does not cover mandatory payments or, in the case of Elliott v. Peru, collections. Legal scholars argue that because sharing provisions and “most favored creditor” or “most favored nation” clauses are also included in sovereign debt documents to address payment priority, the redundancy of a broad interpretation of the pari passu clause implies that its scope only applies to ranking. The practical consequence of a broad interpretation, as cited by aforementioned legal scholars, is that holdouts hold all of the bargaining power in a restructuring and force the government to settle at the detriment of the consenting lenders. There is no incentive for bondholders to consent to a deal if one litigious fund can unravel months of negotiations and receive a better recovery.
I disagree.
Let’s look at these two substitute clauses in detail:
A sharing clause is a common feature of syndicated loans to guarantee that if one of the members of the syndicate receives a greater payment, it will share ratably with the other members
A Most Favored Creditor clause, a common inclusion in workout agreements, is meant to ensure that no one creditor receives more favorable restructuring or payment terms
However, neither of these clauses is equivalent to a pro-rata clause; rather, they specify the equitable treatment of all parties under certain circumstances. Just because these clauses, intended to be executed circumstantially, are included doesn’t mean that the pari passu clause can’t also be interpreted through the lens of payment priority.
What is a lien? It is a right to the collateral that backs the debt in case the debt cannot be paid back in cash at maturity. In other words, a lien is the theoretical order in which financial obligations must be paid out in the event of a default. If the rank of these instruments has been determined at underwriting, why would they not maintain the same priority in all other matters related to their going concern status (i.e., all required activities to avoid an event of default)? In other words, if payments to one pari lender and the lack thereof to another will result in a default across the entire lien, then the pari passu clause must be consistent across the entire life of the instruments and not just at default. With respect to mandatory debt payments, all instruments across a lien should be entitled to ratable payment priority under the pari passu clause.
Diving into the Documents
As a fun thought experiment, the language of the Argentine and Peruvian bond documents confirms this interpretation. Below is an excerpt from Argentina’s FAA bond documents, paragraph 1(c):
“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 vagueness in the legal language surrounding the equal treatment of the “payment obligations” implies that it is, at a minimum, a part of the concept of pari passu and meant to support the preceding statement. The execution of pari passu is not simply limited to an event of default, but is supplemented by all mandatory events leading up to an event of default. In fact, the language for the Peruvian bonds specifically includes interest payments as a pari passu payment obligation:
“The obligations of [Peru] hereunder do rank and will rank at least pari passu in priority of payment with all other External Indebtedness of [Peru], and interest thereon.”
Any argument advocating for the full separation of lien and payment priority permits sovereign nations to treat certain creditors disadvantageously by exploiting vaguely worded language intended to give the false illusion of priority. The Southern District of New York made the correct decision in affirming the unification of lien and payment priority, albeit covering significantly more ground than the Court likely intended to. In reality, the idea of payment priority is quite broad, and the Court was almost certainly referring to mandatory payments, as discussed above (i.e., any scheduled payment required to avoid an event of default). But, what about the other type of payments: optional prepayments? How should those be treated under the pari passu clause? For example, if Argentina decides to issue new bonds, then elects to pay down the debt of only one class of creditors (i.e., through an optional prepayment), should the other pari passu creditors also be paid down in accordance with the pari passu clause?
Surprisingly, the answer lies in U.S. leveraged loan credit agreements.
Corporate Interpretations of the Pari Passu Clause
The truth is that when it comes to the concept of pari passu in corporate credit agreements, there is significantly less room for interpretation. Not only are lien and payment priority well-documented in credit agreements, but they are further bifurcated in intercreditor agreements to handle different aspects of creditor rights. For example, in re Energy Future Holdings Corp. (842 F.3d 247 [3d Cir. 2016]), the Court ruled that the governing provisions of first-lien and the second lien payment disputes lie in the intercreditor agreement and not the waterfall payment rights in the credit agreement. Additionally, many of these intercreditor agreements permit the priority of payments to second lien instruments if there is no event of default, effectively placing all facilities - regardless of lien - as pari passu in payment priority.
Looking at a recent example, AMC Entertainment was one of the first public companies to undergo a liability management exercise, or an aggressive restructuring. The intercreditor agreement includes the following language concerning payments:
“Notwithstanding the lien priorities provided for herein, until the occurrence and continuance Payment Blockage Period or Enforcement Notice, each Second Lien Secured Party may receive and retain payments of principal and interest and other amounts to which they are entitled in respect of the Second Lien Obligations, so long as no Default or Event of Default shall have occurred and be continuing.”
In other words, the second lien is entitled to continue receiving payments alongside the first lien provided that there is no default; the payment subordination structure only kicks in when there is an Event of Default. That’s not to say that the second lien is completely on equal footing as the first lien when it comes to payment priority, but when the borrower is fully solvent and able to make payments, the second lien can and should receive payments. As a result, similar to how an intercreditor agreement must carve out inter-lien payment rights, an intercreditor agreement must carve out intra-lien payment rights as well. Otherwise, the pari passu clause will assume ratable payment priority, as in the following excerpt below:
“Each First Lien Secured Party hereby agrees that if it shall obtain possession of any Shared Collateral or shall realize any Proceeds or payment in respect of any such Shared Collateral, pursuant to any First Lien Security Document or by the exercise of any rights available to it under applicable law or in any Insolvency or Liquidation Proceeding or through any other exercise of remedies (including pursuant to any intercreditor agreement), at any time prior to the Discharge of each Series of First Lien Obligations, then it shall hold such Shared Collateral, Proceeds or payment in trust for the other First Lien Secured Parties having a security interest in such Shared Collateral and promptly transfer such Shared Collateral, Proceeds or payment, as the case may be, to the Controlling Collateral Agent, to be distributed in accordance with the provisions of Section 2.91 hereof.”
Once again, the operating language is “through the exercise of any rights available.” The payment priority, even between instruments of the same lien, will only become exercisable in the Event of Default, which can be avoided, for example, through a forbearance agreement. The complicated part of defining payment priority is when the Borrower is insolvent and selectively makes payments to certain creditors, thereby reducing the available pool for other creditors in the same lien. In practice, most of these cases are then subject to the language of the intercreditor agreement and the Bankruptcy Code. The Bankruptcy Code includes a clawback function under section §547, which states that any payments made 90 days before filing (1 year for insiders) can be clawed back as a part of the proceedings. Once these proceeds are clawed back, they are then subject to ratable distribution under the applicable intercreditor instructions. As a result, non-pro rata distributions of mandatory payments are significantly harder under U.S. credit agreements, given the depth of the documentation.
Having discussed the limited capacity for non-pro rata, mandatory payments, the last piece of the puzzle has to do with optional prepayments. Optional prepayments include excess cash flow sweeps, asset sales, and open market purchases. Optional prepayment waterfalls are generally explicitly carved out in credit agreements and if non-pro rata, agreed upon by all parties. In restructurings, certain parties will opt to forgo optional prepayment rights in exchange for class voting or other protections. In the case that optional prepayments do not have an explicit carve-out for non-pro rata waterfall payments, the waterfall reverts to section 2.18 of standard LSTA agreements, which is strictly pro rata (otherwise known as a silent pro rata treatment). In other words, non-pro rata treatment of optional payments must i) be agreed upon by all parties at underwriting and ii) explicitly carved out in documentation.
Side Note: There are also carve-outs for non-pro rata buybacks in most credit agreements today (thanks to our friends over at Kirkland and Weil). The landmark bankruptcy case for Serta Simmons Bedding, LLC was centered around a clause in the credit agreement that permitted non-pro rata open market purchases and dutch auctions. This allowed the borrower to undergo an aggressive, non-pro rata exchange via an open market purchase of the existing debt. This exchange was overturned on appeal in 2024 (in re Serta Simmons Bedding, LLC, 125 F.4th 555).
The distinction between mandatory and optional payments is clear in U.S. credit documents and leaves little to no room for interpretation of non-pro rata treatment. Elliott v. Peru would likely never unfold under an LSTA document and if it did, it would have to be the result of an unprecedented, ultra-aggressive exchange like Serta Simmons.
Final Thoughts
As a standard of defining payment priority in the pari passu clause - regardless of the issuer, security, or market - it is necessary to bifurcate payment priority into mandatory and optional payments. Under the concept of pari passu, mandatory payments must always be pro rata while optional prepayments must be explicitly and clearly carved out to substitute the pari passu clause; any ambiguity in the documentation should be subject to pro rata treatment under the pari passu clause. Sovereign nations should not be allowed to draft legally ambiguous documents in the hopes that the courts will interpret them in a borrower-friendly light should the issuer default. Assuming a standard across all forms of pari passu instruments will allow for less contentious restructurings, yielding fair and equal recoveries for all creditors.
References
Cases
Elliott Assocs., L.P. v. Republic of Peru, 948 F. Supp. 1203 (S.D.N.Y. 1996), rev’d, 12 F. Supp. 2d 328 (S.D.N.Y. 1998).
NML Capital, Ltd. v. Republic of Argentina, 699 F.3d 246 (2d Cir. 2012).
In re Energy Future Holdings Corp., 842 F.3d 247 (3d Cir. 2016).
In re Serta Simmons Bedding, LLC, 125 F.4th 555 (5th Cir. 2024).
Statutes and Regulations
11 U.S.C. § 547 (2024).
Contracts and Corporate Documents
AMC Entertainment Holdings, Inc., Intercreditor & Collateral Agency Agreement § 2.04.
Echostar Corporation, First Lien Intercreditor Agreement (Exhibit C).
Republic of Argentina, Fiscal Agency Agreement, ¶ 1(c) (FAA Bonds).
Republic of Peru, External Indebtedness Bond Terms.
Books and Secondary Sources
Gregory Makoff, Default: The Legendary Story of the Argentine Debt Crisis and the Hedge Fund That Changed Sovereign Finance (2024).
Philip R. Wood, Law and Practice of International Finance (Sweet & Maxwell, 2007).
Loan Syndications and Trading Association (LSTA), Form of Credit Agreement, § 2.18 (Standard Pro Rata Payment Provisions).