The Debt Frenzy

President Denis Sassou Nguesso of the Republic of the Congo likes to live large. In New York City for a series of U.N. meetings last year, he and his entourage holed up at the Waldorf Astoria hotel, where the president prefers to stay. When his party checked out six days later, their tab came to more than $100,000. Sassou Nguesso racked up more than $20,000 in room service charges alone for items including Cristal champagne. It was just the latest indulgence for the president of the impoverished central African nation, which has a per capita gross domestic product of around $1,700 and an average life expectancy of 54 years. In 2005, the president’’s Manhattan hotel bills exceeded $300,000.

Sassou Nguesso may not have anticipated that his profligate habits would be splashed across the pages of major Western newspapers, as they were earlier this year. But he shouldn’t have been surprised. The president has acquired some resourceful adversaries, with good connections and a desire to expose official excess. Their motive? Congo owes them tens of millions of dollars.

Like most governments, Congo has at various times borrowed large sums of money from Western banks and investors. The transactions make sense in theory. The government gets cash it needs, and investors get a legally binding promise of regular interest payments. But like many other poor and mismanaged countries, Congo soon found that it couldn’t keep up with the payments. Prodded by activist-rock stars like Bono, many Western governments and multilateral institutions have forgiven billions in debt owed by poor countries. But even so, it is only a fraction of what poor governments like Congo owe. These governments must also pay billions to private investors and businesses, who are often far less charitable.

In the case of Congo, money is owed to Elliott Associates, a hedge fund whose specialties include collecting debts owed by governments. From its offices in Manhattan, Elliott has emerged as the chief debt collector to a host of governments. Colloquially, if somewhat invidiously, referred to as "vulture funds," Elliott and several similar hedge funds fight governments to ensure they pay what they owe. The countries that vulture funds chase down are usually poor and frequently corrupt — Liberia, Nicaragua, Peru, Sierra Leone, Uganda, and Zambia, to name a few. Most vulture funds are based offshore and keep a low profile. One of the most aggressive fund managers is Kenneth Dart. He is heir to a Styrofoam cup fortune, lives in the Cayman Islands and rarely speaks to the media. Firms like his buy up the sovereign bonds and other debts of struggling countries, often at bargain basement prices. Then they do what most Western banks aren’t inclined to do and what individual investors don’t know how to do: They sue, harass, and shame debtor governments into paying at least a chunk of what they owe. And they do well. In 1998, Peru paid Elliott more than $58 million for a debt the fund had bought for much less. Nicaragua has been ordered to pay more than $200 million. Just this year, Zambia was ordered to pay a British Virgin Islands-based vulture fund more than $15 million. In all, it is estimated that private creditors hold judgments in excess of $1 billion against some of the world’s poorest countries.

CLAIMING THE HIGH GROUND

Unsurprisingly, vulture funds have become the favorite punching bags of the debt forgiveness movement. "These people are trading in human misery," spits one debt relief campaigner. Congo’s Sassou Nguesso calls the vulture funds "snakes in the ocean" and "thug gangsters." The disdain for these debt collectors is shared in Western capitals, too. "By depleting the resources of developing countries’ governments, these companies reduce the funds available for schooling and hospital treatment," declares a spokesman for Britain’s treasury. Caroline Pearce of the Jubilee Debt Campaign believes that the vulture funds are misguided, even when their targets are middle-income countries that are better positioned to pay. "The way that vulture funds buy out very bad debt and seek to recover as much as possible is not helpful," she says.

Sitting in his understated office in midtown Manhattan, Jay Newman doesn’t come across as socially irresponsible. A portfolio manager at Elliott Associates, he is slight and soft-spoken. But if Newman lacks Bono’s volume, he can almost match him in righteous fervor. His contempt for governments that refuse to pay what they owe runs deep, as does his belief that vulture funds are a critical check on the "moral hazard" of debt default. Where the debt forgiveness activists see poor countries in need of relief, Newman sees corrupt, deadbeat countries "dragging our legal system down by disregarding the rule of law." Newman and his colleagues simply reject the idea that vulture funds are extracting money from the coffers of the poor. "Debt relief advocates should recognize that the beneficiaries of debt relief are often corrupt or incompetent regimes that squander their nations’ assets and then cry poverty to avoid legitimate debts," says an Elliott spokesperson. "This cycle must be broken for countries to achieve economic development."

There will always be countries that cannot pay their bills. Somehow, they and their creditors have to renegotiate the debt — and history suggests that most investors are willing to compromise. In this atmosphere, vulture funds, which usually demand full payment on their bonds, can get in the way. Creditors that might otherwise be willing to accept 60 cents on the dollar may reconsider if a vulture fund can get full value. "It’s like surrendering your seat on a crowded bus in favor of an elderly woman only to watch a teenager wearing a varsity wrestling jacket jump into it," notes Lee Buchheit, an attorney at Cleary Gottlieb, a law firm that represents many governments.

Such is the case with the vultures’ biggest target yet — Argentina. Hardly one of the world’s poorest countries, Argentina is a self-confident Latin powerhouse with a booming economy. Its heated struggle with the vultures is being watched by investors around the world. The outcome will reverberate in global capital and financial markets and influence the behavior of dozens of other governments. Debt forgiveness may have captured the imagination of Hollywood activists, but debt collecting is still a critical part of how the world’s financial system works, and Argentina is putting that part of the system to the test.

ARGENTINA’S CLOSE SHAVE

In December 2001, the financial and political crisis that had been consuming Argentina for months came to a head. Capital was fleeing the country and the government was drowning in debt. Argentina’s leaders decided to stop interest payments to tens of thousands of individual investors, pension funds, and financial institutions that held the government’s bonds. It was the biggest sovereign debt default in history, and it rattled the world’s already jittery financial markets, which were still reeling from the Asian financial crisis and Russia’s economic meltdown.

In Buenos Aires, the government’s decision to default was greeted as a declaration of financial independence. The parliament gave then President Adolfo Rodríguez Saá a standing ovation when he announced the plan. But some officials conceded it was an act of desperation. "We are in a collapse," said one senior Argentine official. "We are broke." In all, Argentina ceased payments on bonds worth more than $80 billion. Thousands of bondholders watched nervously. Many were large financial institutions with diversified portfolios. For them, the Argentine default was an annoyance, not a catastrophe. Others were less fortunate. Thousands of Italian pensioners had bought Argentine bonds in the late 1990s, lured by high interest rates and a blissful ignorance of the country’s brewing financial crisis.

As it became clear that Argentina was in a financial free fall, many investors wanted out, and fast. They were desperate to find buyers for what might soon be worthless sheets of paper. For funds such as Elliott Associates, Argentina’s chaos was a smorgasbord. Economic crises might be startling events for unseasoned investors, but they are a vulture fund’s natural environment. Elliott Associates bought millions of dollars’ worth of Argentine bonds, sometimes for as little as 15 cents on the dollar, even before the country defaulted. Meanwhile, Argentina’s leaders huddled with financial and legal advisors. They came up with a stark choice for their investors: Trade your existing bonds for new ones worth about one third of the original value, or keep the old bonds and get nothing. In bond-market parlance, Argentina’s investors were about to get a "haircut." But this was more than a trim. In most previous restructurings, governments had offered investors new bonds worth 50 to 75 percent of their original value. Argentina, however, was offering only a third of the original value. It was a buzz cut.

Most investors gritted their teeth and took the deal. Suing governments is time consuming, expensive, and uncertain. Moreover, some of the largest holders of bonds were major banks that do repeat business with governments such as Argentina. They had no incentive to anger a customer from whom they might be seeking business in a few months. "Morgan Stanley doesn’t want to spend a dollar of its money hiring lawyers," says one New York hedge fund manager. "Most of these money managers have repeat business with sovereigns [governments]. If they come off as an obstreperous or difficult creditor, they may not get the call from the finance minister to issue the next round of bonds." By 2005, more than 70 percent of bondholders had signed on to the draconian restructuring.

But several hedge funds, together with groups of angry individual investors, mainly from Italy and Germany, decided to stand firm. They held on to their existing bonds and filed a series of lawsuits in the United States. As the legal battle escalated, so did the rhetoric. "If we pay more, as we did in the 1990s, it would be a new genocide," declared Argentina’s President Nèstor Kirchner. "It’s time for the world to put a brake on the vulture funds and insatiable banks that want to keep profiting from a broken and wounded Argentina." When Rodrigo de Rato, managing director of the International Monetary Fund (IMF), suggested that Argentina treat its creditors with respect, Kirchner scoffed, "It’s pathetic to listen to [the IMF] sometimes." To the frustrated bondholders, Argentina’s behavior has been arrogant and reckless. "Argentina is just trying to bully people into accepting an unacceptable offer," says Hans Humes, an asset manager who represents investors holding about $40 billion worth of defaulted debt. As the vulture funds and the Argentines exchange barbs, squadrons of lawyers are fighting the battle in U.S. courts.

PAYING THE PIPER

In May 2006, a New York federal court ruled that Argentina owed an arm of Elliott Associates more than $100 million. Other bondholders, including the mysterious Kenneth Dart, won even larger judgments. In most financial disputes, this ruling would have been a decisive victory. But in the unique arena of litigation against governments, the court’s ruling was just the beginning. Somehow, the vulture funds now had to find a way to force Argentina to pay up. The legal rules that govern companies and individuals have always struggled to control the behavior of sovereign states — even in purely financial matters. For centuries, most Western legal systems treated foreign countries as essentially untouchable in the courtroom. Foreign governments could lend and borrow money, but any disputes about those transactions had to be settled politically, not legally. Frustrated investors could only try to persuade their governments to take up their cause. Usually, such pleas fell on deaf ears. Governments don’t want the private debts of their citizens or companies to complicate diplomatic relationships.

Occasionally, creditors have pushed their governments to act. In 1902, European gunboats sailed into Venezuela’s ports, established a blockade, and sank several ships in an effort to make the country pay on defaulted bonds. Venezuela capitulated. But using gunboat diplomacy to settle debt issues was always rare. And in the 1950s, the United States and Britain decided that better rules were needed. With governments engaging in increasingly complex financial transactions, the notion that they should be immune from the rules that applied to corporations and individuals was untenable. Governments acting for commercial purposes could be sued just like private businesses. The days of total sovereign immunity were over. Then, in the 1980s, another important change occurred. Foreign governments — particularly Latin American governments — shifted their borrowing patterns. Where they had once borrowed mainly from major Western banks, governments began issuing bonds that anyone could buy. The result of these two changes was a new, diverse, and scattered class of creditors that was harder to coordinate and control.

Despite these changes, being a sovereign government still has its privileges. Their funds are usually hidden away or protected by strict rules. A nervous government can stash its reserves in the Bank for International Settlements in Basel, Switzerland, which is legally protected from creditors. As Elliott’s Jay Newman puts it, Argentina’s lawyers are fighting a successful rearguard action. The same New York courts that have said that Argentina owes its bondholders vast sums of money have frustrated all attempts to make the country pay.

In this hostile legal landscape, vulture funds have become adept at sniffing out and seizing government assets. In 2000, Elliott Associates convinced a Brussels court to seize money flowing through a European financial clearinghouse and compelled a startled Peruvian government to settle. Some creditors have been even more inventive. A Swiss businessman owed money by Russia has tried to impound President Vladimir Putin’s private jet, several valuable works of art, Russian planes at an air show, and a historic Russian ship at a regatta. All of these efforts ultimately failed, but creditors remain vigilant. They are now widening their legal assault to include banks and companies that help debtor governments shelter their assets. In its fight with Congo, an Elliott affiliate filed suit against French banking giant BNP Paribas, alleging that it conspired with Congo’s government to shelter oil revenues from creditors. These lawsuits threaten to expose connections with corrupt governments that banks would prefer to keep under wraps.

But for all the fear they inspire, even determined debt collectors are struggling to sustain their efforts. Every time vulture funds find assets to seize, governments close loopholes. Argentina, with the help of Buchheit and other lawyers at Cleary Gottlieb, has proven particularly adept at dodging the vultures. In January, a U.S. appeals court ruled that Argentina’s creditors could not seize funds from the country’s central bank, a major blow to Elliott Associates. A triumphal note has even appeared in Kirchner’s statements. He recently referred to the default as a "finished" matter and the country’s parliament has passed a law forbidding the government from reopening negotiations with holdout creditors. But this smugness may be premature. Frustrated with the legal process, vulture funds are taking to the political arena. Like generations of frustrated creditors before them, they are lobbying for government intervention. That lobbying effort goes by the name "American Task Force Argentina," and it has enlisted Harvard Law School Professor Hal Scott and several Clinton-era officials — including former Under Secretary of Commerce Robert Shapiro and former National Security Council official Nancy Soderberg — to help persuade the Bush administration and Congress to pressure Argentina.

"No one else has behaved this way on the international sovereign debt market," says Shapiro, who takes pains to emphasize that his work is not a simple lobbying exercise, but a major policy effort to restrain Argentina’s dangerous behavior. "Countries much poorer, countries with terrible, corrupt regimes — nobody else has tried this." If Argentina gets away with stiffing its investors, Shapiro insists, other countries may follow suit. He might be right. Ecuador recently sought Argentina’s advice on how to default on its bonds.

A DEBT TO SOCIETY

These moves would be unnecessary if today’s sovereign debt market had a structure for orderly negotiation when a country can’t pay what it owes. Despite the IMF’s best efforts, no equivalent to bankruptcy court has emerged for governments in distress. The World Bank does what it can to help the poorest countries that face aggressive private creditors. Occasionally, it buys claims from debt holders and clears them from the books, though it is only willing to pay about 8 cents on the dollar, not enough to satisfy most private creditors. Debt relief activists provide poor countries with legal advice and mount name-and-shame campaigns to pressure creditors into forgiving debt. But for the most part, the system remains a free-for-all.

The vulture funds often cast themselves as surprised victims of corrupt and untrustworthy governments. In fact, they actively seek out environments where, by dint of aggressive litigation, they can do much better than the ordinary investor. But they also play an important role in the ecosystem of international capital. They create secondary markets for less aggressive investors who want to unload their holdings and, perhaps more important, they inflict pain on countries that default, which most large institutional investors aren’t willing to do. They are, in a sense, the avenging angels of the debt market. "Vulture funds add value," says Mitu Gulati, a professor at Duke University’s law school. "The market would not work effectively if they were not there."

That argument carries little weight with debt relief activists. They point to the ongoing case against Zambia as evidence of the hardship that vulture funds can inflict. The debt at issue was born innocuously enough in 1979, when the Romanian government lent Zambia money to buy tractors. It stayed on the books for nearly 20 years, through the fall of communism in Eastern Europe and innumerable changes of government in Zambia. Then, in 1999, a vulture fund convinced the Romanian government to sell its claim for just a few million dollars. Now, more than two decades after Zambia incurred the debt — at a time when it is struggling with wrenching poverty and a runaway AIDS epidemic — it may end up paying many times the amount it borrowed.

For every Zambia, however, there is an Argentina, which has the means to pay and which has treated its creditors, including elderly Italian and German pensioners, with contempt. Sadly, the international legal system can’t distinguish between the two. In its eyes, an enforceable debt is an enforceable debt. What is sorely needed is something different, a legal mechanism that can inject some equity into the process. A system that will cry for Zambia but punish Argentina. Until then, the vultures will continue to circle.