Weidemaier Research Sheds Light on Sovereign Debt Crisis

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Mark Weidemaier

Sometimes court decisions change the world, like recent federal court rulings interpreting an obscure bit of contract language – the pari passu clause – used in many countries’ bonds. These decisions have shaken financial markets and prompted government officials to worry whether financially distressed countries will be able to reduce their debts. Research by UNC School of Law assistant professor Mark Weidemaier has the potential to change it back.

A novel injunction ordered by Judge Thomas Griesa of the U.S. District Court, Southern District of New York in NML Capital v. Argentina and upheld by the U.S. Court of Appeals for the 2nd Circuit in October 2012 may give sovereign bondholders an incentive to hold out rather than agree to a country’s proposed restructuring.

“This case could make it substantially harder for countries to get debt relief at a time when the global economy has not recovered from a very serious recession,” Weidemaier says.

The pari passu clause is one of the most controversial and mysterious terms used in sovereign bonds. “It has been used for more than a century,” says Weidemaier, “But lawyers candidly admit they don’t really know what it means. The plaintiffs in this case capitalized on that uncertainty to convince the courts it meant something favorable to them, but they also created a huge problem.” With colleagues at other schools, Weidemaier, who specializes in contracts and arbitration, compiled a data set of more than 2,000 sovereign bonds dating from about 1820 to the present. An article he wrote with Robert Scott of Columbia University and Mitu Gulati of Duke draws on this data set to shed light on the meaning of the pari passu clause and will be published in the quarterly journal Law & Social Inquiry.

“We have a clear sense of how the pari passu clause has been used over time,” Weidemaier says.

Countries that need debt relief must persuade bondholders to reduce their claims voluntarily. Most bondholders grudgingly agree, but some sophisticated investors buy distressed country bonds very cheap, planning to hold out from the restructuring. Then, they sue to get paid in full.

“They might buy bonds for 15 cents on the dollar and get paid 100,” Weidemaier explains. “They use creative legal techniques and chase assets all over the globe. They have made a good bit of money doing this.”

Nevertheless, enough creditors participated in restructurings that countries could still get debt relief.

A few years ago, some investors tried a different strategy. The plaintiffs in the NML Capital case own bonds issued by Argentina, which, Weidemaier says, has been called “the world’s greatest sovereign deadbeat” after its default in 2001. The plaintiffs convinced the federal judge in New York that, by agreeing to the pari passu clause, Argentina promised never to pay one bondholder without making an equivalent payment to every other bondholder. The court ordered Argentina not to pay bondholders who participated in its restructuring unless Argentina paid the plaintiffs in full.

“In practical terms,” Weidemaier says, “this decision treats the pari passu clause as a promise never to restructure. But the clause has been around a very long time, and the market has never viewed the clause that way.” Because the pari passu clause is so widely used, he said, the decision in NML Capital may complicate future restructurings.

“The fear is that bondholders won’t agree to provide voluntary debt relief,” Weidemaier says. “Who would agree to take less if they can’t get paid unless other claimants are paid in full?”

New York financial institutions and law firms worry that countries will stop issuing bonds through them and decamp from New York law bonds to English law bonds (the two main foreign law markets). In its ruling, the court of appeals said that other contract terms called collective action clauses (CACs) would compensate for the pari passu ruling. But Weidemaier’s research shows that CACs don’t provide a mechanism for stopping litigation by holdout creditors.

Argentina has petitioned for a re-hearing, and the appellate court has yet to rule on exactly how much the country must pay and on whether banks and other financial institutions are potentially subject to the injunction.

Weidemaier is optimistic that the global financial system is too big to fail due to one court case, but he admits, “There could potentially be a major shake-up in the sovereign debt market in order to limit the ruling’s effect.

“The stakes are enormously high.”

-March 7, 2013

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