November 2000

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Special Comment

How To Sue A Sovereign: The Case Of Peru

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Farisa Zarin Vincent Truglia David Levey Christopher T. Mahoney

How To Sue A Sovereign: The Case Of Peru
Summary Opinion
Over the past four years, Elliot Associates, a relatively small hedge fund based in New York, was entangled in litigation with the Republic of Peru and Banco de La Nacion, a major Peruvian bank. This case made its way all the way up the federal appellate ladder to the Second Circuit Court.1 In short, Elliot Associates was able to get a post-judgment attachment of Peruvian assets in the state of New York. To avoid execution of the attachment, the case was settled out of court for approximately $58 Million.2 In our previous publication on the legal implications of a sovereign default,3 we noted that the recourse available to an investor is really quite limited. Under sovereign immunity law a court will probably grant that the sovereign should make good on its defaulted debt. But that decision is of little practical use to a suing investor because he is unable to attach the sovereign’s assets and force payment.4 The point of interest in the Elliot Associates case is that the plaintiff attained a post-judgment attachment of all assets of the sovereign’s agent, Banco de La Nacion, in the United States. That an entity closely related to the sovereign can conceivably be held financially liable and that all of its assets in the jurisdiction where the suit is brought may be attached to make good on defaulted debt opens a door that had hitherto not been considered available. Of course, the particular fact pattern of Elliot Associates leaves many open issues which will undoubtedly be fought over in courts over the next several years. Two obvious questions that spring immediately to mind are: how will an “agency” be defined; and, what is the necessary nexus between the sovereign, the entity in question and the defaulting instrument. Yet, that an investor may have this option available to it turns his suit from an academic and avenging “I told you so” exercise to a more lethal weapon lending this disconsolate investor’s bark a bit more bite. This case has also raised concerns that proliferation of such suits by aggressive investors could realign incentives of the sovereign and other creditors. After all, when a sovereign settles out of court for a substantial sum with one litigious creditor it will adversely impact, however marginally, the claims of its other creditors. It is possible, and indeed probable, that to protect their interests these creditors will attempt to somehow hinder their uncooperative brethren. We will address the realignment of incentives, as well as the possible reactions from investors and sovereigns, in a forthcoming special comment.
1 2 3 4 Elliott Associates, L.P., v. Banco De La Nacion and The Republic of Peru, 194 F.3D 363. Financial Times, pg. 7, Wednesday October 25, 2000, “Investor ‘Vultures’ Come Under Scrutiny Over Distressed Debt,” by Joshua Chaffin. See “What Happens If a Sovereign Defaults,” Moody’s Special Comment, July 2000. Only property used for the commercial activity in question inside the jurisdiction where the suit is brought may be attached.

Special Comment

continued on page 3

Author Farisa Zarin

Senior Production Associate Susan Heckman

© Copyright 2000 by Moody’s Investors Service, Inc., 99 Church Street, New York, New York 10007. All rights reserved. ALL INFORMATION CONTAINED HEREIN IS COPYRIGHTED IN THE NAME OF MOODY’S INVESTORS SERVICE, INC. (“MOODY’S”), AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, such information is provided “as is” without warranty of any kind and MOODY’S, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling. Pursuant to Section 17(b) of the Securities Act of 1933, MOODY’S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY’S have, prior to assignment of any rating, agreed to pay to MOODY’S for appraisal and rating services rendered by it fees ranging from $1,000 to $1,500,000. PRINTED IN U.S.A.

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Moody’s Special Comment

I. Elliot Associates v. Republic of Peru
We will state at the outset that Moody’s is neither an expert on matters of international law nor portrays itself as one. Additionally, in drafting this special comment we have relied solely on public information and court opinions.5 Finally, the case at hand, as with any legal proceeding, has many nuances and intricacies that we cannot hope to capture. Notwithstanding these caveats, it seems that three very important questions which had somewhat muddied the legal waters of sovereign debt have possibly been made clear through Elliot Assoc. v. Peru:6 a) In case of an exchange offer, does the sovereign’s original debt obligation extinguish? No. If a debt-holder does not participate in an exchange offer, the new terms will not apply to him unless specifically stated under “cram-down” clauses in the original debt instrument.7 The sovereign remains beholden to the non-participating creditors under the old terms. b) If suing a defaulting sovereign, does New York, and English, champerty law require a good faith attempt at renegotiating the terms of the original debt instrument? No. Buying distressed debt and suing the sovereign to make good on its obligation is not against New York champerty law.8 c) When enforcing a judgment against the sovereign, which of its assets can be attached? Two types of assets are attachable: • Those assets of the sovereign in the jurisdiction of the country wherein the suit is brought which are used specifically in commercial activity. • All assets of the sovereign’s “agency or instrumentality” which conducts commercial activity in the country wherein the suit is brought, and which are located in that country’s jurisdiction.

Just The Facts, Please 9
Elliott Associates is an investment fund in New York City specializing in distressed debt. Between January and March 1996, Elliott purchased approximately $20.7 million (in principal amount) of the working capital debt10 of Banco de la Nacion and Banco Popular del Peru.11 The debt was sold under a series of letters of agreements. Elliott paid approximately $11.4 million for these debt obligations. All the debt was guaranteed by Peru pursuant to a written guaranty dated May 31, 1983. Under their express terms, both the letter agreements and the guaranty were governed by New York law. On May 1, 1996, Elliott delivered joint notices of assignments to the debtors’ reconciliation agent to register its purchased debt. The next day, Elliott notified Banco de la Nacion, Banco Popular del Peru, and the Republic of Peru by letter that it was now one of their creditors and that it wished to initiate discussions regarding repayment. A conference call followed, but no negotiations on repayment terms eventuated. Instead, the debtors took the position that Elliott was not a proper assignee as it was not a “financial institution”12 and that Elliott should either transfer the debt to an eligible financial institution or participate in the Brady Plan under consideration with the other creditors.13 Peru’s Brady Plan necessitated an exchange agreement under which old Peruvian commercial debt, including the 1983 letter agreements, would be exchanged for Brady bonds and cash.14
5 6 7 See infra note 15. Although many similarities exist between US and English legal systems, this analysis only holds for the United States. As such, no legal matter is truly settled with 100% degree of certainty unless it is heard by and decided upon by the US Supreme Court. There is a fundamental difference between English Law bonds and New York Law bonds. English Law bonds generally have a super-majority collectiveaction-clause (CAC) which enforces the new terms of the exchange instrument on all debt-holders. For New York Law bonds, the terms and condition of the payment of the original instrument are only enforceable on all original debt-holders if they unanimously agree. For a better description of the differences between New York and English Law bonds, see Andrew Yianni, “Resolution of Sovereign Financial Crises: Evolution of the Private Sector Restructuring Process,” in Bank of England, Financial Stability Rev. 78, 80-81 (June 1995) Section 489, New York Law Judiciary Law: Purchase of claims by corporations or collection agencies. The facts as presented here have been drawn from the 2nd Circuit summary of facts, see supra note 1, 194 F.3D 363, 364-369. The Peruvian sovereign debt purchased by Elliott was working capital debt, rather than syndicated bank debt. Working capital debt does not involve an agent bank, but instead consists of direct loans between single lenders and borrowers. Syndicated bank debt is debt syndicated by a lead bank, which maintains books and records for all holders. Because the buyer has to rely upon the seller, rather than an agent bank, to convey good title, working capital debt typically trades at a discount of several percentage points from syndicated debt. Banco de la Nacion is the National Bank; m Banco Popular del Peru is now bankrupt. Within the scope of the assignment provision of the Letter Agreements. Typically, the terms of a Brady Plan are negotiated with the debtor country by an ad hoc committee of the nation’s largest institutional creditors, generally known as the “Bank Advisory Committee.” The members of the Bank Advisory Committee commit to restructuring the debt that they hold on the agreed terms and those terms are also offered to other creditors. However, while the members of the Bank Advisory Committee usually agree to be bound by the negotiated terms, the other creditors are under no such obligation to accept those terms. The plan was agreed to by 180 commercial lenders and suppliers.

8 9 10

11 12 13

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Moody’s Special Comment

3

On June 25, 1996, after a period of standoff between the parties, Elliott formally sent the debtors a notice of default. The notice was sent during the voting period on the term sheet of Peru’s Brady Plan. And although the Brady Plan negotiations took place from January to June 1996, Elliott did not contact the Bank Advisory Committee to express its views. On October 18, 1996, ten days before the exchange agreement was scheduled to be executed, Elliott filed suit against the debtors in New York and sought a prejudgment attachment order. The exchange agreement was finally executed on November 8, 1996.

What Happened In Court?15
That Peru’s Brady plan had not extinguished the claims of holdout creditors was a point of no contention. The two somewhat controversial issues in Elliot Assoc. v. Peru were that: • Whether the litigious nature of the plaintiff bars him access to the legal system; • And more importantly, which assets of a sovereign’s “agent or instrumentality” can be attached if that agent or instrumentality conducts commercial activity, defined loosely, in the United States.

Litigiousness Is Not Grounds For Dismissal
Section 489 of the New York Judicial Law prohibits the purchase of a claim “with the intent and for the purpose of bringing an action or proceeding thereon.” This champerty provision is based in old English law and its fundamental public policy purpose is to ensure that suits are not brought as a means of laying burdensome costs on to the defending party. Put simply, the legal system should be used appropriately rather than to create unnecessary costs for society.16 It therefore begs the question: is an investor specializing in buying distressed debt and then suing in the event of default breaking the law? Must he, instead, try to understand the sovereign’s precarious situation and attempt to cooperate, i.e. renegotiate, with the sovereign? On appeal, the Second Circuit answered the question by simply noting that “the main and primary purpose of the purchase” 17 was not to bring a suit, but rather to collect on the debt that was rightly owed. Legal recourse was secondary and contingent. It was resorted to only for the protection of the rights of the plaintiff, which is its proper usage.

All Assets Can Be Attached
“Pursuant to 28 U.S.C. section 1610(b), execution against property of Defendant Banco de la Nacion to satisfy this judgment is limited to property in the United States.”18

That Peru and Banco de la Nacion had defaulted was not the main question of this series of litigation. All courts agreed that when Elliot Associates did not participate in the 1996 exchange offer it remained in full possession of rights under the debt instruments that it had purchased in the secondary market. The heart of the matter, rather, was how would Elliot Associates force the defendants to make good on the default? What assets, within US jurisdiction, were permitted to be attached under the Foreign Sovereign Immunities Act?19 Under section 1610(a) of the statute only sovereign assets used in commercial activity with a nexus to the defaulting instrument in question can be attached.20 Generally speaking, this does not leave much, as most countries keep their property and their assets within their own jurisdictions.

15 See, e.g., Elliott Assoc. L.P. v. Banco de la Nacion, 194 F.R.D. 116 (S.D.N.Y. 2000); Elliott Assoc. L.P. v. Banco de la Nacion, 194 F.3d 363 (2d Cir. 1999) (Elliott V); Elliott Assoc. L.P. v. Banco de la Nacion, 12 F. Supp. 2d 328 (S.D.N.Y. 1998) (Elliott IV); Elliott Assoc. L.P. v. Banco de la Nacion, 176 F.R.D. 93 (S.D.N.Y. 1997); Elliott Assoc. L.P. v. Banco de la Nacion, 961 F. Supp. 83 (S.D.N.Y. 1997); Elliott Assoc. L.P. v. Banco de la Nacion, 948 F. Supp. 1203 (S.D.N.Y. 1996; Elliott Assocs., L.P. v. Banco de la Nacion, 2000 U.S. Dist. LEXIS 14169 (S.D.N.Y. Sept. 29, 2000)). 16 Black’s Law Dictionary, Sixth Edition, pg. 231. Champerty is defined as: “A bargain between a stranger and a party to a lawsuit by which the stranger pursues the party’s claim in consideration of receiving part of any judgment proceeds; it is one of “maintenance,” the more general term which refers to maintaining, supporting, or promoting another person’s litigation. 17 Appellate decision, see supra note 1, at 379-380. 18 Elliott Assocs., L.P. v. Banco de la Nacion, 2000 U.S. Dist. LEXIS 14169 (S.D.N.Y. Sept. 29, 2000), at 9. 19 Foreign Sovereign Immunities Act (FSIA), 28 U.S.C.S., section 1602 et seq. 20 Sovereign Debt: What Happens if a Sovereign Defaults?, see supra note 3.

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Moody’s Special Comment

Consequently, Elliot also sought attachment of all of Banco de La Nacion’s assets within the United States. The court granted the attachment under Section 1610(b) of the Sovereign Immunity Statute,21 which provides:
(b) any property in the United States of an agency or instrumentality of a foreign state engaged in commercial activity in the United States shall not be immune from attachment in aid of execution, or from execution, upon a judgment entered by a court of the United States . . . if[. . .] (2) the judgment relates to a claim for which the agency or instrumentality is not immune by virtue of section 1605(a)(2), (3) or (5), or 1605(b) of this chapter, regardless of whether the property is or was used for the activity upon which the claim is based.22

Furthermore, the FSIA defines an “agency or instrumentality of a state” as an entity which is a separate legal person, corporate or otherwise; an organ of a foreign state or political subdivision thereof; neither a citizen of a State of the United States …., nor created under the laws of any third country.23 In this case, all parties agreed that Nacion was indeed an “agency or instrumentality” of Peru, the foreign state.24

Conclusion
Given the FSIA’s fuzzy verbiage in defining an agency or instrumentality and the fact that most sovereigns have little assets outside of their country, we are likely to see this matter vigorously litigated in the future. Nevertheless, at this point in time it appears that when suing a sovereign a creditor may attach all assets, located in the jurisdiction wherein the suits is brought, of an entity related to the sovereign and somehow involved in the matter, if that entity is: 1. An agency or an instrumentality of the defaulting sovereign and; 2. Engaged in commercial activity in the United States.

21 The Court also referred to the Restatement (Third) of the Foreign Relations Law of the United States, at 460, cmt. b. (“For purposes of post-judgment attachment and execution, FSIA draws a sharp distinction between the property of states and the property of state instrumentalities: (i) the property of states may be attached only if it is or was used in commercial activity; (ii) the property of state instrumentalities may be attached without any such limitation, so long as the instrumentality itself is engaged in commercial activity in the United State. These distinctions reflect the premise that state instrumentalities engaged in commercial activities are akin to commercial enterprises, so that immunity is exceptional and limited, whereas the primary function of states is government and, absent waiver, their liability should be limited to particular claims and their amenability to post-judgment attachment should be limited to particular property.) 22 FSIA, see supra note 19, section 1610(b). 23 Id. 24 Sept 29, 2000 decision, see supra note 18, at 8.

Moody’s Special Comment

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Special Comment

How To Sue A Sovereign: The Case Of Peru

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