Par pass.

Unless you have studied Latin, these two words probably seem
like gibberish that is no concern of yours. However, this unassuming phrase has
been incorporated into bond contracts since the 1970s and is incorporated into
almost all bond contracts since the 1990s. (Moore, 2014) Recently, it has brought
the sovereign debt industry into a serious state of confusion. Dusting off my Latin
translation skills, this phrase, in the ablative, is a combination of a noun, passus,
meaning a step and an adjective, par, meaning comparable or equal in importance.
Since the phrase is in the ablative, you could make the translation with equal
step. In the context of a bondholder, the interpretation of this phrase implies that
every bondholder is to have equal standing. You are probably still asking yourself,
why does this matter?

Headlines have been full of the Eurozone crisis and Argentina's technical
default, now there are growing concerns over Ukrainian debt sustainability; all of
this chatter has made sovereign debt and, more specifically, sovereign default, a
hot issue in the financial world. This issue brings together the political and financial
worlds, as ramifications for both sovereign development and investor returns exist.

Governments finance themselves externally in a combination of two ways:

multilateral loans, organized by institutions like the IMF and World Bank, and the
issuance of debt instruments, usually bonds. The US makes great use of the system
and our bonds, more commonly referred to as T-bills, are about as liquid as cash and
are held by investors around the globe with near zero default risk. Other countries,
especially developing nations like Argentina and small nations like Greece, do not
enjoy such a preferred borrowing status in global markets. Not only are they usually
unable to issue debt in their own currencies, but they also must offer higher interest
rates in an effort to attract investors and raise much needed capital for
development. Investments in developmental policy, much like investments in new
companies or large projects, are inherently risky due to the uncertainty of success.
Throughout the development of a countrys economy there are industries and
investments that fail and there are ones that succeed. None of this should come as
a surprise, and assumingly should be built into the price of the securities issued.
This raises the question, are sovereign bonds adequately pricing risk?

The discussion currently encompasses what is absent from the contracts of

bonds: an orderly, defined, enforced, and fair procedure for defaulting sovereigns.
The international debt regime is virtually nonexistent. Every time a sovereign
defaults or is in need of restructuring, chaos and uncertainty ensue at a detriment
to all involved. Undoubtedly, these crises have an impact in slowing the growth of
developing nations. The typical debt crisis tends to drag on for a decade or longer.

For example, Argentinas selective default, declared only about a month

ago, is in reference to a bond issue that the government defaulted on in 2001 and
proceeded to restructure in 2005 and 2010 (Mander, Moore, and Rathbone, 2014).
In Argentinas case, they have been successfully pushed into default on the entire
bond issue as a result of a court case brought against the sovereign in New York by
NLM Capital. NLM Capital is considered to be a vulture fund, which is a hedge fund
that purchases sovereign debt at an incredible discount, often only a few cents on
the dollar, for the sole purpose of attempting to litigate against them for the face
value of the bonds. Should these actors even be entitled to the same rights by the
courts considering the amount of their investment is small compared to other
bondholders?

Due to the aforementioned lack of debt regime, these companies are able to
use their ample resources and capital to engage in litigation in the sovereigns own
country, the country where the debt is issued, through multinational organizations,
and even through other treaty-defined arbitration avenues. The odds are usually
stacked against the creditor in these situations because sovereign assets and
actions are supplied with ample protection and a certain level of diplomatic
discretion is usually involved as well. However, in this case and a few others, the
creditor appears to have succeeded, possibly resulting in huge returns. A judge in
New York ruled that due to his interpretation of the par pass rule, Argentina
cannot continue to pay the restructured bonds while withholding full repayment
from the holdouts. This judge took the decision even further by attaching an
enforcement mechanism to the decision, an action previously not pursued allowing
sovereigns to merely ignore court decisions. The enforcement mechanism prevents
the US bank from disbursing Argentinas payment to the restructured bondholders,
due to the fact that doing so would be mean the bank was acting in concert with the
sovereign and therefore just as responsible. Since the bank is clearly under US
jurisdiction, it would be severely penalized. Does this decision misinterpret the
original intention of the par pass clause implying equal treatment by denying the
restructured bondholders their repayments in the interests of a few holdout
investors?

Scholars and many investors view this ruling as troubling. The implications
are yet to ripple through the system and many are awaiting Argentinas next move.
Olivier Blanchard, chief economist at the IMF, referred to the decision as having a
cost to the world (Mander, Moore, and Rathbone, 2014). Inherently, the recent debt
crises highlight a severe market failure between sovereign issuers and private
creditors. This is an ongoing and recurrent issue and this decision, seemingly giving
vulture funds an upper hand, could bring even more turmoil and uncertainty to
sovereign debt.

Although there is consensus on the problem, there are multiple competing

theories as to the solution. Some scholars see the solution resting in new types of
bond clauses that override the new idea of par pass and give sovereigns the
ability to implement binding restructurings, others believe multinational institutions
need to establish binding rules regarding defaulting nations, and others still see a
solution residing within the establishment of arbitration standards so that creditors
and debtors have a more equal standing. (Day, 2014, p. 247-8) When private
actors enter into bankruptcy proceedings, there is an amount of certainty in what
certain creditors stand to gain and lose as a result of proceedings. They willfully
accept the risk of these proceedings by purchasing the bond. However, when a
sovereign enters into an impending default, a creditor enters a realm of uncertainty
that, according to holdouts and vulture funds, was never fully agreed to as part of
the bond contract. How can investor interests be protected without undermining
the sanctity of many sovereign assets?

It is unreasonable to expect investors to accept no inherent guarantees as to

a return on their investment, but it is also unreasonable to bankrupt a sovereign
nation and throw fragile economies into tailspins, affecting a nations citizens in
huge ways. In his analysis, Day comments that economic theory indicates that
efficient markets must enforce contracts so that ...signatories may choose to
perform the promise specified in the agreement or pay its comparable expectation
damages (2014, p. 256). As long as the norm involves at least a decade of
litigation and such large degrees of uncertainty, the sovereign debt market cannot
be considered efficient. Some sort of middle ground must be found and enforced so
that efficiency can return to the sovereign debt market and ever important capital
flows continue to spur economic development in emerging markets. However, it is
easy to question if this middle ground can even exist between a private actor and
sovereign entity.

The overarching question posed to the international and investment

communities is in what way should and, more importantly, could more defined and
rigid processes, similar to private bankruptcy structures, be translated and applied
to sovereign debt?

References
Day, G. (2014). Market Failure, Pari Passu, and the Law and Economics Approach to
the Sovereign Debt Crisis. Tulane Journal of International and Comparative Law,
22(2), 226-262.

Mander, B., Moore, E., & Rathbone, J.P. (2014). Argentina: Unresolved debts, The
Financial Times. Retrieved from http://www.ft.com/intl/cms/s/0/96b56394-1d6811e4-b927-00144feabdc0.html?siteedition=intl#axzz3DRNE0M27