By Kenneth H. Fukuda

May 2008

Vulture funds have been described by the worst of terms. They have been described as funds that pounce on a state like a vulture on a rotting carcass. Vulture funds are exploitative financial funds in which a private fund buys up cheap foreign debt, and sells it at a much higher cost. Vultures have been used to describe all types of financial ventures involving debt, not just sovereign debt. For example, corporate vulture funds have raised US$15.6 billion in the first seven months of 2007. Even mainstream investment banks such as Goldman Sachs have become involved, as they have put together nearly US$20-30 billion worth of funds. In the sovereign debt context, vulture funds attack some of the poorest countries in the world. Nearly US$1.5 billion worth of lawsuits are currently pending against eleven of the poorest countries in the world. These lawsuits pose a serious problem because the vultures complicate the debt restructuring process. Furthermore, as this FAQ will point out, vulture fund holders can virtually hold nations hostage to their debts through these lawsuits. Therefore, many of these debtor states have no choice but to succumb to the demands of vulture funds.

This FAQ provides an overview of a vulture fund. First, it will address the basic fundamentals of the vulture fund. Second, it will briefly outline the history of vulture funds. Third, it will document the case studies of Peru and Zambia. And finally, this FAQ will conclude with a brief examination of some solutions to this “sovereign piracy."

I. The Basics of a Vulture Fund

A vulture fund is a fund or investment company that purchases debt claims as a secondary lender. This means that vulture funds are not primary lenders, but rather are entities that have purchased the debt from some other source, such as a bank. Generally, these funds purchase debt involving highly distressed countries. The sellers of these debts usually are more than willing to rid themselves of these debts because many of these debts may soon come into default or face restructuring negotiations. Thus, the vulture funds purchase this debt as it is about to be written off. (Banks will write off loans as a loss if they believe that the borrower will no longer be able to repay the loans.) Then, the vultures sue the debtor or borrower for the full value of the debt, plus interest. The lawsuits occur in national courts, often in the United States, Paris, or Brussels. Through litigation and negotiation, vulture funds have been able to secure a payout greater than the cost of the vulture's purchase.

A. The Use of Litigation to Enforce Debts

One of the primary reasons why vulture funds are successful is because courts have been willing to enforce a vulture fund's right to collect the full value of the debt. Nations such as Zambia, Peru, Argentina, etc., have lost lawsuits to vulture funds.

One of the primary and highly successful arguments justifying full enforcement is the inclusion of a standard “pari passu" clause in many sovereign debt agreements. Pari passu clauses require that all creditors be treated equally. Accordingly, a prominent Brussels court has held that pari passu clauses forbid states from paying only the restructured portion (as explained below) without paying the vultures as well. Therefore, if there is not enough money to go around, all creditors receive a pro-rata share and debtors are not allowed to pay off one creditor in full while leaving others unpaid. Because these clauses contractually prohibit a state from paying off one creditor before other holdouts, these clauses can act as a “large hammer" in the hands of holdout creditors. This has the effect of either forcing states to appeal court decisions that stop the restructuring because of the pari passu clause, or pay up in a settlement agreement with the vulture fund so that debt restructuring can take place.

B. The Holdout Creditor's Hammer to Impede Debt Restructuring

The hammer referred to above references the power a holdout may have over a sovereign debt restructuring process. Debt restructuring often is an effective means to alleviate some of the national debt load without going into default, and restructuring debt can promote a sustainable debt service load. This frees up funds for domestic development. Restructuring often results in payments of less than the face value of the debt. However, the threat of successful litigation by a holdout can impede a successful restructuring process. Depending on how much debt a vulture fund owns relative to the total restructuring, a refusal to participate in the restructuring by the vulture fund could complicate the entire restructuring process. Such holdouts can be a primary barrier to orderly sovereign debt restructurings.

The hammer wields its power because of the pari passu clause. The pari passu clause, as stated above, contractually bars a state from paying off the restructured debt prior to paying off a vulture fund. Thus, the prospect of a holdout may discourage creditors from agreeing to a restructuring, because (1) creditors now can collect the full amount of the debt by suing, and (2) restructuring may be stopped by the courts under the pari passu argument.

Even if a country chooses to restructure its debts despite the vulture's threat of litigation, vulture funds have been successful in their use of courts to stop payments to creditors under the restructuring agreement. For example, a court stopped Peru from paying off some of its bondholders because the pari passu clause prevented Peru from paying off other debts without also paying off the vulture fund.

Therefore, unless holdouts are paid, they may be able to call for a default for nonpayment. For example, in Peru (which will be discussed in further detail below), the vulture fund stopped Peru from making a payment to other creditors. If a state chooses not to pay the vulture fund, that fund could call a default. On the other hand, when the state is prevented from paying the other creditors by a vulture fund, those other creditors may call for a default. This likelihood of default may prompt a rush to grab the sovereign's limited foreign exchange reserves, as creditors will attempt to get at whatever they can before a state goes into default. Most importantly, the ability to call a default by a vulture fund can trigger cross-default clauses in other debts. This may result in a massive default that will ultimately impede restructuring. Thus, the pari passu clause, which prevents a state from paying off restructured debt prior to the vulture fund, is an effective hammer utilized by vulture funds to gain full (or nearly full) payout. As one scholar writes, “[t]hose inclined to be holdouts have a stronger position, and it encourages others to hold out. For the sovereigns…this is a nightmarish situation. The result is likely to be that the threat [of a lawsuit] will force sovereigns in distress to turn to more extreme forms of renegotiation."^[1] Ultimately, this prevents an orderly restructuring that would benefit the people of the debtor country. Vulture funds then, result in more monies going to pay off sovereign debts instead of being used for badly needed domestic development programs.

II. History of Vulture Funds

Vulture funds were generally non-existent until the mid-1990s due to how sovereign debt was held. Sovereign debt traditionally had been held by bank syndicates, and these syndicates understood that a rush to collect debt immediately or a holdout by any creditor would serve none of their interests. Furthermore, these banks shared some common interests, such as a desire to secure future business from these debtor countries and a desire to follow the desires of bank regulators. Filing lawsuits to enforce debts would be contrary to those interests, and therefore, the banks stopped litigation by exerting peer pressure on fellow institutions. Creditors, therefore, did not sue to enforce debts. Any holdout creditor or vulture fund would be blacklisted from international banking. Furthermore, many national governments also prevented debt holders from embarking upon a road towards becoming vulture funds. For example, banks progressing down a road towards becoming holdouts might be called by a governmental bank regulator, and be threatened with a financial audit and review.

By the mid 1990s, however, much of the syndicated debts had been converted to freely-traded sovereign bonds. In the early 1980s there was a major debt crisis in Latin America. The crisis begin in 1982, and from 1982 until 1989, there was a long period of restructuring sovereign debt. Many of these debts were held as unsecured syndicated bank loans. It was clear that by 1989, and despite the restructuring plans, the Latin American states were not in any better financial health. In response, U.S. Treasury Secretary Nicholas F. Brady designed the “Brady Plan" in an attempt to address the Latin American debt crisis in March 1989. Under the Brady system, loans were exchanged for sovereign bonds that could be freely traded. By 1998, it was evident that sovereign debt had converted from syndicated bank loans to securitized bonds. Brady bonds have become a generic term for bonds issued during sovereign debt restructuring, but specifically refer to the exchange of commercial bank loans for bond instruments.

With the creation of the sovereign bond market, non-bank investors began to hold substantial amounts of sovereign debt. Such investors with divergent interests were growing in number and became increasingly difficult to manage. This eliminated the peer and regulatory pressures on holdouts. Therefore, without these pressures, there was less reason for creditors to follow the old rules.

III. Cases and Examples

The effect of this shift was that there were fewer deterrents to vulture funds. Peru was the first major example of vulture fund victimization. Elliott Associates, one of the prominent vulture funds, changed the nature of sovereign debt restructuring. Its success in getting Peru to pay the full debt led to other funds pursuing the vulture mentality. Elliott Associates is thought to be the “creator" of the vulture fund. Other states, such as Zambia, have also fallen victim to the vulture fund activities.

A. Peru

Peru was one of the first nations to face a vulture fund lawsuit. In 1983, Peru was in dire economic straits. At that time, Peru announced that it did not have the funds to manage its debt, and could get no more credit. After its announcement, Peru negotiated with creditors and settled various debts. In 1984, there were more negotiations to provide a long-term solution. This did not work, however, and Peru eventually imposed restrictions on payment of foreign debt. From 1984-1992, Peru only paid interest. Eventually, by the early 1990s, Peru was in default, and entered into negotiations to restructure its debt. Several funds, such as the Pravin Banker Associates, however, refused to participate and sued Peru for repayment.

The most prominent lawsuit, however, was brought by the Elliott Associates vulture fund. In the mid 1990s, Peru announced it would restructure its debts in the form of Brady Bonds. Around the same time, Elliott Associates purchased US$20 million of Peru's debt for US$11.4 million. Elliott likely acquired this debt specifically for the purpose of enforcing it. Elliott Associates, in their own words, wanted “Peru to pay [Elliott] in full or be sued."^[2] Elliott's holding of Peruvian debt was the only debt held outside the Brady Bond restructuring scheme. Peru refused to pay off Elliott immediately, so Elliott sued to enforce the debt and Elliott obtained a US$55.7 million judgment, which included interest and legal fees.

Post-judgment, Peru still attempted to pay off the Brady bondholders before Elliott Associates. Elliott responded by filing for an injunction to prevent Peru from paying off the restructured debt without first paying off Elliott. Elliott successfully argued that the pari passu clause, included in a 1983 New York law-governed debt agreement, required Peru to treat all of its creditors equally. The Court of Appeals in Brussels agreed, and Peru was contractually prohibited from paying off one creditor at the expense of another. With the judgment, Elliott utilized additional means to acquire payment. Elliott used American courts to “attach" those Peruvian payments designated to pay off the other debt holders. A series of court actions by Elliott tied up those attached Peruvian payments, where instead of the Peruvian payments reaching bondholders, they were being held by the court. Because the bondholders were not being paid, Peru nearly defaulted on its newly restructured debt. To avoid defaulting on its Brady Bonds, Peru chose to settle by paying US$56.3 million to Elliott.

B. Zambia

Zambia provides a very recent example of a vulture fund in action. In 1979, Zambia borrowed US$15 million to pay for farm equipment. Zambia's economy ran into trouble, and was unable to keep up with payments. In 1999, Zambia and Romania agreed to liquidate the loan for US$3 million. Before the deal was completed, however, Donegal International purchased the debt for less than US$4 million. Donegal International, a vulture fund, was created for the sole purpose of collecting Zambian debt. Donegal International sued Zambia, and in 2007, Zambia was ordered to pay US$15 million.

In Donegal's suit, Donegal sought nearly US$40 million because of interests and costs. The lawsuit triggered grave concerns from politicians and consultants worldwide. A consultant to Oxfam (a non-governmental organization, which, among its other activities, combats sovereign debt), Martin Kalunga-Banda, noted that the amount sued for was equal to all the debt relief Zambia received the year before. Moreover, had Donegal been able to enforce the full US$40 million, the impact would have been severe. One hundred thousand people would have lost medical services. Services involving teachers, nurses, and badly needed infrastructure projects would be cut. The Jubilee debt campaign condemned Donegal's actions as cynical profiteering.

Taking into account many of these criticisms, the Royal Court of Justice refused to order the full payment of the US$40 million. Instead, it ordered the payment of US$15 million. The case was eventually resolved for US$15.5 million, after taking into account interest and other costs.

IV. Combating the Power of Vultures

Various NGOs, such as Oxfam and Jubilee, have embarked upon efforts to combat and stop vulture funds. These funds, according to critics, have negative effects upon developing countries. The vulture fund's actions limits debt relief, thereby saddling national economies with huge debt loads. Money saved from the global movement to cancel debt eventually falls into the hands of vulture funds. Furthermore, achieving full payment (plus accrued interest) through litigation not only deprives developing nations of much-needed resources, but also presents a classic case of unjust enrichment. This is because vulture funds purchase sovereign debt, with no ethical expectation of full payment (except through litigation). But the vulture funds still do it anyway at the expense of highly indebted poor countries. Finally, vulture funds prevent orderly debt restructuring. As mentioned above, pari passu clauses act as a hammer to impede or prevent restructuring. These clauses prevent countries from paying the full amount to the most important creditors, who may be able to keep debtor countries afloat. The clauses, rather, force payments pro rata—leading states to default on ALL loans instead of just a few.

The International Monetary Fund (IMF) has proposed several ways to combat the power of vulture funds. The remainder of this FAQ will address the main possible solutions proposed by the IMF: a bankruptcy-style framework for sovereign states. We will also touch on several other solutions, such as collective action clauses and comity.

A. SDRM

Many proposals to restructure the international finance system are similar to American bankruptcy laws. The IMF proposed a “Sovereign Debt Restructuring Mechanism" (SDRM). The IMF proposed a framework because the current international financial system was not suited to promote a predictable and orderly restructuring of sovereign debt. This unpredictability often drove the cost of default even higher. An SDRM offers legal protection for a debtor country, in exchange for an obligation to negotiate with its bondholders in good faith. According to Ms. Anne Krueger, a former official of the IMF, this mechanism would have had a high level of involvement by the IMF. Under this system, the IMF was to agree that restructuring was necessary, and then supervise the negotiations, restructurings, and eventual bond and debt exchanges. Furthermore, the proposed IMF process would have been mandatory for debtors and creditors, and ultimately would have bound holdout creditors to the restructured agreements.

An SDRM has several key features. First, states could go to the IMF for a temporary standstill on repayments without a risk of default. Such a stay would allow the state to negotiate with its creditors for more reasonable repayment terms and general restructuring. This step would have also prevented creditors from seeking repayment through national courts. This, however, required an international law prohibiting creditors from seeking repayment in all countries; otherwise creditors would specifically pick out friendly countries to enforce debts.

Second, an SDRM includes some mechanisms that ensured a debtor country would act responsibly. These mechanisms to promote responsibility would have been similar to the same mechanisms the IMF utilizes in its other debt assistance programs. Furthermore, to promote responsibility, the temporary standstill would have had a Fund-established maximum time limit.

Third, the IMF would have provided some encouragement to private lenders to provide fresh money to assist in financing. According to Ms. Krueger, such financing was in the collective interest of all parties, because when the new financing is used responsibly, a state could have limited the adverse economic impact and protected the domestic economy's ability to generate resources to pay off existing debt. Furthermore, the additional money could have covered trade credits and finance payments to priority creditors. Nevertheless, it was quite possible that lenders would be reluctant to provide additional financing. To induce financing, there would have been assurances that the additional loan money would be senior to all pre-existing debts.

Finally, an SDRM would discourage vulture funds by implementing a majority clause in restructuring agreements. Once a restructuring agreement was reached and agreed to by a large enough majority, minority creditors would be bound. The level of majority needed was unclear—but later proposals required either supermajorities or arbitration if there are minority holdouts to the restructuring.

B. Other Methods

A different method of discouraging vulture funds would be through Majority Action or Collective Action Clauses (CACs). CACs have been endorsed by many official entities. The G-10 endorsed the usage of CACs in 1996, and a broader group of states followed suit in 1998. IMF communiqués have called for the implementation of CACs by growing economies. CACs gained steam after March 2003, at which time Mexico's bond issue, under New York law, included a CAC. Almost all sovereign bonds after that issue included CACs. By 2006, 60% of outstanding sovereign bonds included CACs.

CACs are clauses in bond agreements that permit restructuring, as long as a majority or a supermajority of creditors approves the restructuring. CACs dampen the power of vulture funds by eliminating the legal basis by which a vulture fund can hold out. A CAC forces all creditors to accept a restructuring decision approved by a sufficient majority. For example, in the Peru case, had there been a CAC in their bond agreement, Elliot Associates may have been forced to accept the debt restructuring agreement. Elliot may then have had no legal basis to bring a lawsuit as a holdout creditor.

Another option is the comity defense. Comity is a judicial doctrine that permits a U.S. court to respect the actions of a foreign sovereign, as long as they are consistent with U.S. law and policy. International comity, as defined by the Supreme Court in the 1895 case of Hilton v. Guyot, is the recognition one country gives to another's laws. This refers to the notion that domestic courts should not act in a way that infringes upon the laws of another nation. Thus, under the comity defense, U.S. courts should not enforce vulture fund-held debt out of respect for foreign sovereign's wishes to restructure debt.

Comity as a defense to vulture funds, however, can only be supported if discouraging vulture funds is in the line with U.S. policy. Discouraging vulture fund litigation would be consistent with U.S. law and policy. The U.S. and the IMF are intertwined, because U.S. courts have announced that the IMF policies can be construed to also represent US interests. Congress has authorized the U.S. executive director of the IMF to negotiate debt-restructuring plans that are in line with proper banking practices. Therefore, because vulture funds can undermine IMF-backed restructurings, it also undermines U.S. interests. Otherwise, the U.S. government would be promoting one policy through the IMF and another, contradictory policy, through her courts.

Recently, the George W. Bush Administration and the U.S. government have raised the possibility that comity may prevent the collection of Zambian debts by Donegal. United States House of Representative member John Conyers has stated that the doctrine of comity may allow President Bush to order the US courts to defer to foreign nations when an individual sues a sovereign state. If President Bush forces U.S. courts to defer to the Zambian state, then Donegal may not be able to collect Zambian assets in the United States.

V. Conclusion

Vulture funds have been described in some of the most heinous of terms. They have been accused of engaging in extortion, extreme profiteering, piracy, and outright unethical behavior. At its basic core, however, vulture funds are simply a type of highly profitable financial investment, in which a fund buys sovereign debt cheaply and then sues to enforce it. Nevertheless, vulture fund victims tend to be the poorest of the world's countries. There are currently over US$1.5 billion in lawsuits in which a vulture fund is a party. Eleven HIPC (Heavily Indebted Poor Countries) nations face these vulture lawsuits. And, unless some framework for sovereign debt restructuring is put into place, the movement begun by Paul Singer, the founder of Elliott Associates, will continue to flourish at the expense of the world's poor.

FOOTNOTES:

[1]G Mitu Gulati and Kenneth N. Klee. “Sovereign Piracy." 56 BUS. LAW. 635, February 2001. (Elliott Associates was able to hold out from restructuring, and ultimately forced payment)

[2]Jubilee 2000 Coalition. “Vulture Fund Investors Make Millions out of Third World Debt Misery", http://www.jubileeresearch.org/jubilee2000/news/vulture141000.html.

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