Vulture Funds in the Sovereign Debt Context
A secondary market for debt is a fundamental feature of sovereign borrowing and lending. When creditors can freely sell the debt they hold on the secondary market, there is less risk involved in lending to sovereigns, and creditors are therefore more likely to provide the capital sovereigns need.
In recent decades, as the secondary market for debt has developed, new players have arisen, leading some to question whether the “tradable debt model” for sovereign debt is appropriate. One set of such players is called “vulture funds” - the term given to entities that purchase distressed debt on the secondary market, where it trades significantly below its face value, and then seek to recover the full amount, often through litigation. These intransigent creditors are able to litigate because most debt relief initiatives such as that for HIPCs do not alter the legal rights and obligations between HIPCs and their external creditors. Accordingly, until the HIPC debtors and their creditors reach bilateral legal agreements in line with the HIPC initiative, creditors are legally entitled to use available legal mechanisms to enforce their credit claims against HIPCs. In some instances, prior to decision point some HIPCs have paid commercial creditors in full either because of the litigation or the threat of litigation, a desire to avoid disrupting a commercial relationship, or the fear of losing productive assets in cases where commercial debt was secured by collateral.
Vulture funds buy debt often at deep discounts with the intent of suing the debtor for full recovery. Vulture funds have averaged recovery rates of about 3 to 20 times their investment, equivalent to returns of (net legal fees) 300%-2000%. The vulture fund modus operandi is simple: purchase distressed debt at deep discounts, refuse to participate in restructuring, and pursue full value of the debt often at face value plus interest, arrears and penalties through litigation, if necessary. The vulture funds grind down poor countries in cycles of litigation, a practice referred to as “champerty” and largely unknown in African legal systems. Litigation is typically protracted with many lawsuits taking three to ten years to “settle.” Legal documents indicate six years as a conservative medium estimate for recovery, which suggests that annualized returns average 50 to 333 percent. Some of these claims were bought at roughly 10 percent of face value, implying very high gross recovery rates. Subtracting legal costs, often recouped from the sovereign, these recovery rates are probably the highest in the distressed debt market.
A willingness and ability to pursue litigation appears central to the strategy and success of the vulture funds. In one recent case against Zambia, a vulture fund, having bought a debt for US$3 million, sued Zambia for US$55 million and was awarded US$ 15.5 million. The vulture funds exert pressure on the sovereign debtor by attempting to obtain attachment of the government’s assets abroad. Such proceedings are always burdensome to the debtors concerned, and can complicate financial and reserve management. By precluding debt relief and costing millions in legal expenses, these vulture funds undermine the development of the most vulnerable RMCs.
The IMF reports that in some cases the claims by vulture funds constitute as much as 12 to 13 percent of a country’s gross domestic product (GDP). The IMF reports that eleven HIPCs have been targeted so far in forty-six lawsuits and that the litigators (plaintiffs) are concentrated in three countries. The lawsuits are concentrated in only a few courts. Some lawsuits are reportedly also in HIPCs.
Generally, these vulture funds have won their lawsuits. Twenty-five judgments in favour of vulture funds so far have yielded nearly US$1 billion. Out of this amount 72% of the judgments have been against RMCs. Significantly, the reported number of outstanding cases against debtor countries has doubled since 2004. On average eight new cases are filed each year. This figure includes lawsuits filed in year 2006 and part of 2007. It is anticipated that the success rate of past litigation would generate even more lawsuits against HIPCs. At least three RMCs namely Liberia, Cote d’Ivoire, and Sudan have large commercial creditor claims that are likely to be raised against these countries, although it is not yet clear who holds the various claims.
Litigation is costly for these debtor countries and distracts financial and other authorities from important policy issues. These lawsuits threaten the core objectives of the HIPC initiative. The lawsuits effectively reduce the impact of the debt relief for the HIPCs and cause inequitable burden sharing among creditors. The IMF foresees a risk of taxpayer backlash in the affected creditor countries when taxpayers realize the amount of their taxes being used to pay claims from vulture funds. The vulture fund problem is encouraging opaque financial management, as HIPCs devise ways to shield or hide assets from aggressive creditors.
The central criticism of the vulture funds is that, by purchasing distressed debt at discounted rates, refusing to participate in voluntary restructurings, and seeking to recover the full value of the debt through litigation, vulture funds are preying on both other creditors and on the indebted countries themselves. Countries whose debt is trading at deep discounts are almost by definition in deep financial trouble and many of them are poor. Holdout behaviour by vulture funds makes restructuring slower, more difficult, and uncertain. Debtors are harmed by the substantial uncertainty faced and also by being forced to repay individual creditors far more than the agreements negotiated with other creditors.
At least twenty heavily indebted poor countries have been threatened with or have been subjected to legal actions by commercial creditors and vulture funds since 1999 including Sierra Leone by Greganti Secondo and ARCADE, and by Industrie Biscoti against Cote d’Ivoire and Burkina Faso. Other RMCs that have been targeted include Angola, Cameroon, Congo, Democratic Republic of the Congo, Ethiopia, Liberia, Madagascar, Mozambique, Niger, Sao Tome and Principe, Tanzania, and Uganda.
A joint IMF and World Bank study has observed that although in many cases debtors have not made payments on court judgments obtained by creditors, in some cases debtors have made payments in excess of HIPC parameters. The study further observed that pending litigation and outstanding court judgments may also inhibit HIPCs from regularizing financial relationships with the international banking community. The World Bank estimates that more than one-third of the countries which have qualified for its debt relief have been targeted with lawsuits by at least 38 litigating creditors with judgments totalling $1 billion in 26 of these cases.
The Paris Club has expressed concern with vulture fund litigation. Taking stock of the harmful consequences of litigation for HIPC countries and consistent with the Paris Club principle of comparability of treatment, in May 2007 the Paris Club resolved to avoid the sale of their claims on HIPCs to other creditors who do not intend to provide debt relief under the HIPC initiative. The Paris Club urges other creditors to follow suit. In cooperation with relevant international institutions, the Paris Club creditors agreed to intensify their work on this issue with a view to identifying concrete measures to tackle this problem. In a Pre-summit statement issued in Essen, Germany on 19 May, 2007, the G-8 Finance Ministers expressed concern about actions of some litigating creditors against HIPCs and agreed to work together to identify measures to tackle this problem based on the work of the Paris Club. On 12 December 2007, the G-7 Debt Experts invited the IMF, the World Bank and the Bank to a meeting in Paris chaired by the Secretary General of the Paris Club to discuss the impact of vulture funds on debt relief and measures that could be employed to minimize the adverse affect on economic development of HIPCs.
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