Emerging Markets Research November 2012

Argentina: The Potential EM Precedent for Technical Default (a Crash-Course in Pari Passu Holdout Litigation and Restructured Bond Payment Mechanics)

Vladimir Werning vladimir.werning@jpmorgan.com 212-834-4144

Lessons in basic Latin (and French)

Latin Pari passu Pro rata

English translation On equal footing In proportion

Representing Potential US court precedent Proposed payment remedy Legal option of next to last resort and of last resort

Affected parties Favoring defaulted debt investors Challenging performing bond investors Available to the debtor in arrears

En banc and Certiorari

Review by entire bench and review by a higher court

U.S. Court defines creditor subordination: absent a cram-down procedure, a sovereign paying restructured debt but not paying holdouts breaches pari passu
The merits of Argentinas defense were decisively and comprehensively struck down by the Appeals Court. The Court determined that: Argentina subordinated creditors by breaching the pari passu bond clause The Court interpreted the resolved a contractual ambiguity in sovereign bonds by interpreting the meaning of the pari passu clause. In doing so it distinguished two types of potential subordination that the clause protects creditors from: The Securities will constitute direct, unconditional, unsecured and unsubordinated obligations of the Republic and shall at all times rank pari passu and without preference among themselves (1). 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 (2). (1) The equal rank provision: Prohibition of Argentina as bond issuer from issuing debt of higher priority than defaulted claims (2) The equal treatment provision: Prohibition of Argentina as a bond payer from paying on restructured bonds without paying on defaulted claims. The Appeals Court held that Argentinas breach of pari passu involved the 2nd sentence. Argentina subordinated creditors by enacting the Lock Law (Ley Cerrojo) The lock law prohibits the Executive from negotiating with holdout creditors absent prior consent from the Legislative. It was originally enacted (2005) to increase participation in the sovereign debt restructuring (by signaling to investors that Argentina would not easily re-open the proposal) and it was suspended once (2010) to allow investors subsequently interested in participating, a 2nd chance.

Its all about the remedy now: U.S. Court must still determine an adequate remedy for the breach since the October 26 Appeals Court ruling was incomplete

District Court judgments against Argentina are AFFIRMED in part (by Appeals Court) Ruling: The Court upheld the District Court conclusion that Argentina subordinated litigating creditors by both: breaching pari passu and enacting the Lock Law. Remedy: Orders Argentina to make concurrent or advance pro rata payment to (pre-restructuring) defaulted debt claims whenever it makes payments on restructured performing debt claims(1). and REMANDED in part (by D.C.): Determination of the pro rata formula. Provision: Enjoins financial intermediaries and prohibits them from aiding and abetting Argentina in evading court orders by (a) paying restructured debt without making ratable payments on defaulted debt or (b) altering or amending the payment process for restructured debt(2). and REMANDED in part (by D.C): Clarification of financial intermediaries enjoined. the mandate should return to this court for further consideration of the merits of the remedy Implications: Setting a precedent for EM debt (i.e. not just an Argentina-specific ruling) The Courts primary attention to the interpretation of the pari passu clause in sovereign debt contracts (a broad definition of creditor subordination) sets a precedent for all sovereign issuers. Secondary attention is paid to the interpretation of Argentinas Lock Law (a narrow or Argentinaspecific definition of creditor subordination).

A pro rata remedy is disruptive: it lowers probabilities of payment on performing bondsits as close to a food fight between sovereign creditors as possible
Risk of technical default: A sovereign like Argentina with willingness and capacity to pay restructured bonds may lack a mechanism (access to US payment, clearing and settlement system) to do so. This can occur if (assuming an adverse ruling) a sovereign like Argentina chooses not to pay holdouts 1. AND the Court orders Argentina to refrain from paying certain third parties (restructured bondholders) through the US payment system. 2. AND Argentina attempts to pay restructured bondholders as normal (in the US). BUT third parties (financial intermediaries in US) that are enjoined might refuse the payment (Argentinas property remains offshore) or decide not to complete the transaction (bondholders property will sit idle in trust for an undefined period). 3. AND Argentina attempts to pay restructured bondholders (outside the US) by re-routing payments. A portion of restructured debt will remain performing (for investors accepting new payment location) while another portion can go unpaid (for investors not accepting new payment location).

The Appeals Court states that the pro rata remedy is NOT an attachment of sovereign property (NOR of restructured bondholders property) Instead, (7 years after a restructuring) the District Court orders the sovereign to start making ratable payments to holdouts whenever restructured bond payments are made The practical implication of the remedy is to transform the debt service of sovereign restructured bonds into contingent payments

Discussion topics arising from the partial ruling: The important issues (the breach of contract being defined and the precedent being established)
BREACH (ALREADY AFFIRMED): Interpretation of pari passu A relevant discussion to revisit when (and if) Argentinas petition for review en banc or (likely petition for) certiorari is accepted and the odds of the ruling being overturned increase Argentina challenges the breach of pari passu interpreted by the Court and disputes that pro rata can be an adequate remedy for breach of pari passu Argentina considers the remedy restrains offshore sovereign assets protected by FSIA (pro rata may not be imposed where attachments cannot) PRECEDENT (ALREADY DISCHARGED): Implications of ruling for EM sovereigns The ruling implies an important shift in power favoring litigating creditors relative to sovereign debtors in distress. The Appeals Court dismissed relevant repercussions for sovereign restructurings due to inclusion in EM bonds since 2003 of collective action clauses(CACs) in sovereign bonds. The investor community disagrees on CACs (amicus briefs: CACs constitute an imperfect cram down mechanism and any contribution to investor coordination in a restructuring is effectively undermined with the introduction of a remedy like pro rata). For practical purposes sovereigns in restructurings (or not) are being told by a US court that their use of FX will be conditional. Investors considering a sovereign restructuring are being told by a US Court that a debtors (post-restructuring) access to the US payment system will be conditional on a pro rata (possibly 100%) payment on defaulted debt

Discussion topics arising from the partial ruling: The urgent issues (the feasibility of applying the proposed remedy and the risk of technical default)
REMEDY (PENDING RULING): Adequateness of proposed pro rata formula 1. Completing the District Court ruling: - Clarifying injunctions by determining: (a) determining pro-rata formula (technical) Argentina considers pro rata is inadequate and not equitable (b) identifying financial intermediaries (critical) NYFRB is requesting due diligence on the latter - Extending (or not) the stays on the injunctions Holdouts propose Argentina place a bond with Court instead 2. Completing the Appeals Court ruling: - Affirming or not injunctions by: assessing the (a) pro-rata formula (technical), (b) impact on financial intermediaries (critical) TECHNICAL DEFAULT (PENDING ACTIONS): if Argentina does not pay holdouts 3. Argentinas response: With or without Courts granting the petition for review 4. BoNYs response: Resolving a potential conflict between indenture and court order BoNY will seek Court explicitly resolve its conflict to minimize risk of indemnity Holdouts suggest BoNY indenture trust adequately provisions for that conflict in favor of complying with a court order

Who is challenged? Pro rata challenges $39 bn. exchange securities = $28 bn. bonds (adj. principal value) + $12 bn. GDP warrants (residual notional value)
Argentina: Sovereign obligations $ billion Total | % of GDP | Performing obligations | | GDP warrants (residual=notional*net cap) | | Debt (fixed principal) | | Bonds (incl. held by govt agencies) | | | FX-denominated | | | | Exchange bonds | | | | o/w ARG law | | | | ARG law bonds | | | ARS-denominated | | o/w Exchange bonds | | Loans and IOUs | | Private creditors (FX+ARS) | | Official creditors (FX) | | IFIs (FX) | | Argentina (FX+ARS) | | | Gov't agencies | | | Central Bank (BCRA) | | Other | Non-performing obligations | Paris Club (exc. or incl. interest) | Holdouts (if restructured as in 2010) Breakdown by creditor Private sector % of GDP IFIs and other
Argentina: Exchange securities $ billion

Actual Adjusted 179.2 203.5 36 41 173.0 188.8 15.8 173.0 173.0 123.6 123.6 80.2 80.2 33.9 33.9 6.3 6.3 46.3 46.3 43.4 43.4 21.9 21.9 49.4 49.4 12.3 12.3 34.9 34.9 17.9 17.9 17.0 17.0 1.4 1.4 15.6 15.6 2.2 2.2 6.2 14.7 6.2 9.2 5.5 57.0 12 24.1 78.3 16 27.1

Total Exchange securities Bonds (fixed principal) NY-law (USD) UK-law (EUR) UK-law (JPY) ARG-law (USD+ARS) GDP warrants (notional or residual) NY-law (USD) UK-law JPN-law AR-law (USD+ARS)

Actual 55.8 11.7 15.5 0.4 28.2 43.9 17.2 14.8 0.6 11.3

Adj* 71.6 55.8 15.8

* Adjusted is the sum of bond principal + GDP warrant residual GDP warrant residual = notional * [48% cap - 12% (coupons paid)]

Argentina: Exchange Securities s.t. pro rata $ billion Total foreign law Exchange securities Bonds (fixed principal) 27.6 GDP warrants (notional or residual) 32.6

39.3 27.6 11.7

Its literally (not genuinely) a Catch 22: Pro rata challenges 22% of Argentine sovereign bonds (i.e. those under foreign legislation paid through BoNY trust)

Argentina: Obligations challenged by pro rata threatened As % of Affected Remainder Securities, as % of: Exchange securities 54.9 45.1 Bonds, as % of: Exchange bonds 49.4 50.6 Total bonds 22.3 77.7 Debt 15.9 84.1 GDP warrants, as % of: GDP warrants 74.3 25.7

The relevance of the matter (for Argentina): Bonds challenged by pari passu litigation represent about 22% of Argentine bonds and 16% of gross sovereign debt GDP warrants challenged represent 75% of total warrants

The paradox of the matter (for bondholders): As risk of NY law enforcement (on defaulted bonds) increases, the value of NY law (on restructured bonds) decreases The domestic law risk premium (NY law discount) is currently trading at a discount (NY law premium)

Who stands to benefit in the cash bond market from a ruling against Argentina?: The me toos are uncertain but the upper bound is $6.2 bn. ($7.5 bn. - $1.3 bn.)
Defaulted claims (pending resolution since
Argentinas 2001 default) that could benefit from the Court ruling on pari passu are referred to as me toos Total holdout defaulted claims are 8% of original eligible claims given that 92% participated in restructuring (2005 and 2010). Of the 8% in default about 2/3 are NY law and can aspire to benefit from a US court ruling. When a judicial claim is awarded the creditor loses the contractual provisions of the original defaulted claim (including, for instance, the pari passu clause) Defaulted bonds used in prior litigation against Argentina (attempts to attach assets of ANSeS, BCRA, BNA, BHA, etc) were transformed into judicial claims

Argentina: Defaulted claims $ billion Total defaulted claims (principal + pre-judgement PDI) o/w under NY law o/w converted to court claims in non-pari passu litigation o/w remain bonds with pari passu o/w in pari passu litigation 11.2 7.5 ??? ??? 1.3

For this reason it is believed that litigating creditors have sought equitable relief on original defaulted bond claims

Potential me toos < $6.2 bn ($7.5 bn - $1.3 bn - $? bn)

The pro rata remedy: Alternative formulas to gross up debt payments on restructured bonds for the purpose of satisfying holdouts equitable relief
Defining Ratable payment = Payment %(1) x Total amount currently due(2) (1) Payment % = $ Amount actually paid / $ Amount then due (on restructured bonds) Amount actually paid (not controversial) = Coupon on restructured bonds Amount then due (?) = Could refer to coupon or principal on restruc. bonds (a) if = $ coupon => Pay = 100% claim (b) if = $ restruct. principal (post-HC) => Pay = 5.5% p.a. (2012) (c) if = $ orig. principal (pre-HC) => Pay = 1.8% p.a. (33.7%*Ppl*5.5%) (2) Total amount currently due = $ Amount of claim (on defaulted bonds) Amount of claim (two alternatives) (d) Principal + Interest = $1.33 bn (e) (Ppl + Int) x 2005 haircut = $0.45 bn bond + $1.3 bn GDP Seeks to answer: What claims are plaintiffs being recognized ? Seeks to answer: What are restructured bondholders getting paid?

The pro rata remedy: Alternative formulas to gross up payments

Payout under alternative definitions of pro rata formula: Note: Given PDI claim included in litigation (but excluded in Argentinas restructuring) no pro rata formula fully equates holdouts with restructured bondholders (i.e. even alternative 4. does not constitute a strict cram down) More Preferable for litigating holdouts 1. (a) x (d) = Full claim (paid upfront) = $1.3 bn. STANDARD CLAIM & PAY

Likely Holdouts request (Argentina challenged as inequitable but did not offer an alternative) 2. (b) x (d) = Full claim (amortizing pay) = $70 mn. p.a. STD CLAIM, PROPORTIONAL PAY

Possible. If judge seeks to minimally approximate equity with restructured bondholders 3. (c) x (d) = Full claim (restruct. payment) = $24 mn. p.a. STD CLAIM, CRAM DOWN PAY Unlikely. Only if judge seeks to more closely approximate equity with restructured bondholders 4. (a) x (e) = Restructured claim (upsized by PDI) CRAM-DOWN CLAIM & PAY

Unlikely. The judge would be prioritizing equity and aiming to establish a Chapter 11 precedent for sovereigns in benefit of Argentina (despite not having attempted to do so since post-2001 default litigation began) More Preferable for Argentina and restructured bondholders

What a pro rata remedy might imply: A standard (upfront) payment would be = 9% of Argentinas 2012 debt service (but 50% if max. me toos are considered)

$ billion, except where noted Principal PDI Total USD-NY law Litigating Max. "me toos" 6.8 0.8 4.0 4.6 0.5 3.5 Total 11.2 1.3 7.5

Defaulted claims

Alternative pro rata formulas Standard (upfront) Proportional (p.a.) $ bn % debt serv $ bn % debt serv 1.33 7.50 8.5 48.1 0.07 0.41 0.5 2.6

The pro rata remedy: Potential timing of its (possible) application is a focus

Pro rata of payments: Argentina pays coupons every 3 months on at least one of several foreign law Exchange Securities (Disc 33s, Pars 38, Rep 17s, GDP warrants) being involved in litigation If a pro-rata remedy is affirmed, it can be applied to each one of those payment dates until litigating claim is extinguished Pro rata payments do not affect coupons on Argentine law securities (Exchange Securities and other bonds), even those in USD

Risk of technical default: Markets anticipate a potentially adverse legal process will end in < 1 year (CDS curve inversion) Possible pending judicial steps District Court remands (expect Dec 1) Normal Appeals Court re-hearing (pending) En banc Appeals Court hearing (requested) Supreme Court certiorari (pending request)

Next steps: A nerve-wrecking December with many unknowns

STAYS KNOWNS UNKNOWNS

Expedited judicial process: Distric Court Nov 14: Holdout creditors file brief IN PLACE Nov 16: Argentina files brief Argentina files for en banc review Third parties file amicus briefs Affidavit from Argentine government Nov 19: Holdout creditors file brief POTENTIAL EXTENSION Dec 1 : District Court delivers clarifications to Appeals Court District Court considers petitions to extend stays (or plaintiffs request for Argentina to post bond) Restructured Securities s.t. pro rata: upcoming coupons Only those with payment routed via BoNY bondholder trustee (i.e.: all issued under foreign law, irrespective of FX-denom.) Dec 2: Republic 17s (USD-NY law) Dec 15: GDP Warrants (USD-NY law and EUR & JPY-UK law) (?): Acceptance/rejection of en banc (A.C) Likely rejected Dec 31: Discount 33s (USD-NY law and EUR & JPY-UK law) Mar 31: Par 38s (USD-NY law and EUR & JPY-UK law)c Oct 26 + 90d?: Argentina petition for certiorari (S.C.) (?): Acceptance/rejection of certiorari Dist. Court: Will consider while A.C. does further work Requests judge lift stays without applying injunctions immediately (?) in exchange for requiring Argentina to post a bond (which a sovereign may not accept) NY FED: In 2003 presented an amicus associating pari passu to payment system terrorism. In 2012 presented a brief requesting due diligence when specifying enjoined financial intermediaries

Continuation of judicial process: Appeals Court

(?): Filing of holdout + Argentina + amicus briefs (?): App. Court further consider merits of the remedy Key issue: injunctions application to fin. institutions (?): Completion of ruling from A.C. incl. remands

Market pricing of technical default

Market huge fear of technical default within one years time is reflected in the CDS curve inversion

Market anticipation of a potential mitigating factor (i.e., Argentina re-routes restructured debt payments off-shore returning debt to performing status) is reflected in a wide CDS-bond basis A potential re-routing of payments would be NPV positive for investors given the negative local law premium prevailing today.

Who stands to benefit in derivatives from a ruling against Argentina AND its potential refusal to pay holdouts?: Holders of (adequate tenor) CDS protection

Argentina: Sovereign CDS outstanding

$ billion. both scales 60 58 56 54 52 50 48 46 44 42 40 Gross exposures Net exposures 2.8 2.7 2.6 2.5 2.4 2.3 2.2 2.1 2.0 1.9 1.8

Dec-10

Jun-11

Dec-11

Jun-12

Timing of litigationas well as its outcomeis key to potential CDS pay-out

Outstanding (net) contracts on Argentine CDS have declined to $1.85 billion from this years peak of $2.65 billion

Risk of technical default: Where does it lie within the payment chain and why ?
Off-shore On-shore Risk of Courts restraining order being applied on THIRD PARTIES

Technical default risk: YES Payment risk: YES

Technical default risk: NO Payment risk: YES

Technical default risk: NO Payment risk: NO

ARG (Bs As)

Property is transferred

Obligation is extinguished

Funds are distributed

Funds are disposable

Bond Holder (NY)

Formally (according to the indenture), separate processes in the payment chain

Risk of technical default: A payment chain is as strong as its weakest link

Off-shore On-shore DTC USD NY law Registered Holder Cede Co. Participant Holder Beneficiary Holder

Bondholder trustee ARG (Bs As) BoNY (Bs As) BoNY (NY)

EUR, JPYUK law Registered Holder BoNY Euroclear

Participant Holder

Beneficiary Holder

Property is transferred

Obligation is extinguished

Funds are distributed

Funds are disposable

Argentina claims that the remedy violates FSIA as BoNY receives Argentinas funds off-shore BoNY defines itself as indenture trustee of bondholders Holdouts are disputing BoNYs role, claiming it has an agent relationship with Argentina

Argentina might attempt to argue that it extinguishes its obligation with bondholders when trustee receives funds (before registered holders)

The NY Fed wants the Court to assure it that the potential remedy does not contradict legislation in place that protects the payment system

Bondholders could seek indemnity if BoNY rejects funds or if funds sit idle in trust (or at level of registered holder) Bondholders could accelerate bonds if Argentina imposes an involuntary rerouting of payments (benefiting bondholders yet breaching contract)

Risk of technical default: A payment chain is as strong as its weakest link

Off-shore On-shore DTC USD NY law Registered Holder Cede Co. Participant Holder Beneficiary Holder

Bondholder trustee ARG (Bs As) BoNY (Bs As) BoNY (NY)

EUR, JPYUK law Registered Holder BoNY

Participant Holder

Beneficiary Holder

Euroclear Property is transferred Obligation is extinguished Funds are distributed Funds are disposable

ARGENTINAS OPTIONS: Pays BoNY funds for restructured bonds and pro-rata for defaulted bonds 1- Pro-rata formula = restructuring (cram down) Acceptable to Argentina, but unlikely 2- Pro-rata formula follows any other definition MOST unlikely, unacceptable to Arg Pays BoNY funds for restructured bonds MOST likely if stays extend or BoNY receives Re-routes payments for restructured bonds Practical difficulties, an option if BoNY rejects 1- Uses CAC to cram-down (implies change legislation) 2- Offers exchange (implies change legislation) Defaults on all restructured bonds Unlikely

Risk of technical default: A payment chain is as strong as its weakest link

Off-shore On-shore DTC USD NY law Registered Holder Cede Co. Participant Holder Beneficiary Holder

Bondholder trustee ARG (Bs As) BoNY (Bs As) BoNY (NY)

EUR, JPYUK law Registered Holder BoNY

Participant Holder

Beneficiary Holder

Euroclear Property is transferred Obligation is extinguished Funds are distributed Funds are disposable

BoNYs OPTIONS: Refuses payment NOT likely in December (requires 90 day notice) Receives payment (generating conflict between 1 and 2) 1- Retains funds/seeks court guidance MOST likely (if stays lifted) BUT risks litigation from bondholders 2- Transfers funds to registered holders MOST likely (if stays extend) BUT risks contempt of court/aiding and abetting charges (if not) 3- Transfers funds to court NOT likely (order is NOT an attachment)

Risk of technical default: A payment chain is as strong as its weakest link

Off-shore On-shore DTC USD NY law Registered Holder Cede Co. Participant Holder Beneficiary Holder

Bondholder trustee ARG (Bs As) BoNY (Bs As) BoNY (NY)

EUR, JPYUK law Registered Holder BoNY

Participant Holder

Beneficiary Holder

Euroclear Property is transferred Obligation is extinguished Funds are distributed Funds are disposable

DE JURE BORDERLINE DETERMINING TECHNICAL DEFAULT (potentially disputed by Argentina) Bonds accelerate (30 day grace, 25% vote) Bonds cross-default CDS triggers (4 conditions, ISDA vote) 1- Non-payment 2- Moratorium 3- Restructuring 4- Acceleration

Risk of technical default: A payment chain is as strong as its weakest link

Off-shore On-shore DTC USD NY law Registered Holder Cede Co. Participant Holder Beneficiary Holder

Bondholder trustee ARG (Bs As) BoNY (Bs As) BoNY (NY)

EUR, JPYUK law Registered Holder BoNY Euroclear

Participant Holder

Beneficiary Holder

Property is transferred

Obligation is extinguished

Funds are distributed

Funds are disposable

Business as usual

Potential spill-over from technical default: Index eligibility/investor sponsorship

External debt index eligibility: A technical default in and of itself (i.e. Argentina transfers property of funds to BoNY trustee but obligation is not extinguished as BoNY does not credit Cede and 25% of bondholders accelerate) would not cause removal from the EMBI suite (EMBI+, EMBI Global and EMBI Global Diversified). For instance, note that currently, Belize and Ivory Coast remain in the index and that Argentina remained in the index in 2002 prior to the original exchange. The primary factors to determine index eligibility going forward are size, liquidity and legality. The instruments need to maintain at least US$500 million outstanding and have sufficient liquidity to get daily pricing. The bonds must also remain G-7 law (and pay out in USD). A potential exchange or successful re-routing of payments by Argentina that replaces existing foreign law with local law (or local currency) instruments would result in removal from the EMBI suite, even when original cash flows are not changed.

Argentina: Index weights

% of total

Total AR Discount 8.28% due 33 AR Discount 8.28% due 33 Exch AR Par Step-up due 38 AR Republic 8 3/4% due 17

EMBI Global Diversified 1.56 0.67 0.24 0.45 0.19

EMBI Global 1.09 0.47 0.17 0.31 0.14

Potential spill-over from technical default: The economy and the private sector
Monthly private capital outflows and parallel exchange rate
$ bn, both axes 5 4 3 2 1 0 2008 2009 2010 2011 2012 USDARS gap wrt spot rate (implied in bond prices) Outflows* Capital controls 50 40 30 20 10 0
Domestic interest rate and official exchange rate
%, p.a. 20 15 10 5 0 Jan 10 ARS/USD (30-day depreciation) May 10 Oct 10 Mar 11 Aug 11 Jan 12 Jun 12 Interest rate

BCRA tightly manages official FX rate (relevant for merchandise trade and debt transactions) and domestic interest rates
Stock market valuation
Index, Jan 2011=100 a b 110 100 90 80 70 60 Argentina 50 Jan 11 Jul 11 Jan 12 Jul 12 a) Argentina election; b) Capital controls; c) YPF nationalization; d) NY litigation c US d

JPM estimates for October 2012

Capital controls have proven effective to eliminate net private sector outflows by mid-year 2012. At the same time, capital controls have produced a sharp widening of the parallel peso exchange rate (relevant for capital account transactions) Direct economic consequences (i.e. capital outflows) of a partial technical default (involving 22% of sovereign bonds) may be constrained near-term due to (a) effectiveness of capital controls to limit BoP impact and (b) under-levered private and public sector balance sheets Indirect consequences (i.e. limited external capex financing, narrower trade balance and increased economic isolation) stemming from a partial technical default remain a concern

Brazil

Corporate valuations have suffered increasingly from idiosyncratic risks since capital controls were put in place Higher credit risk premia from a technical default can further devalue corporate equity

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