The Curious Case of Aurelius Capital v. Puerto Rico

In the 1990s, the hedge-fund manager Kenneth Dart figured out that by buying distressed debt and then suing debtor countries in major Western courts, he could make a tremendous amount of money. During the Brazilian debt crisis in 1992, after other creditors had given up and settled, Dart sued Brazil for repayment on over $1.3 billion of debt — and won a better settlement than the others. As Dart’s copycats learned, distressed-debt litigation rewarded patience and creativity. When Paul Singer, the founder of Elliott Management, was owed money from Argentina, for instance — an obligation he pursued throughout a 14-year legal ordeal — Elliott’s subsidiary NML Capital filed a lawsuit in Ghana to take possession of an Argentine Navy frigate temporarily docked near Accra. (Elliot won its case in Ghana, but the decision was overruled by the International Tribunal for the Law of the Sea.) Amazingly, this was not the strangest episode of that crisis: In 2009, Argentina’s National Museum of Fine Arts held back certain paintings from a planned exhibit in Frankfurt because it feared that if the artworks left the country, German bondholders would seize them. This past spring, the hedge fund Contrarian Capital Management — through a shell L.L.C. called Red Tree Investments — filed two claims that are pending in the Southern District of New York against the national oil company of Venezuela for $182 million of debt, which Contrarian purchased on the secondary market. Because they are perceived to swoop down on sick prey, firms like these are sometimes called “vulture funds.”

When Dart and Singer started, fewer than 10 percent of sovereign-debt crises involved litigation. Today that figure is more like 50 percent. Further, according to a working paper from the German monetary-policy think tank CESifo, when there is litigation, there’s now a two-thirds chance that the plaintiff is a hedge fund. Because many hedge funds make use of shell corporations or nested L.L.C.s, it’s impossible to quantify how much government debt around the world they actually hold. But Mark Weidemaier, a professor of law at the University of North Carolina, Chapel Hill, whose research focuses on sovereign-debt litigation, explained that today, when a government or city hits financial turbulence, “it’s unquestioned that a substantial portion of its debt is going to wind up in Wall Street hands.”

How it winds up there is important. When a government issues bonds, the first buyers tend to be vanilla investors like central banks or mutual funds, who willingly pay face value in exchange for the promise of regular interest payments. It’s only when something bad happens (missed payment, military coup, recession), and the bonds start trading significantly under face value on the assumption they will not be fully repaid, that the more creative investors’ ears perk up. Unlike the first wave of bondholders, who care mostly about interest and stability, these distressed-debt investors care mostly about the actual bond paper, which theoretically entitles them to full repayment and furnishes interest along the way as a lagniappe.

In addition to Aurelius, a handful of kindred entities hold Puerto Rican paper: Monarch Capital Master Partners, Pinehurst Partners, Senator Global Opportunity Master Fund. Nearly all the bonds that Aurelius holds are a preferred kind called “general obligations,” or G.O.s, which have traded everywhere from 99 cents to 20 cents on the dollar since they were issued in 2014. According to Matt Fabian, a partner at the bond-research house Municipal Market Analytics, a standard estimate would say that funds like Aurelius acquired G.O.s at an average cost of 50 cents on the dollar, or about $180.3 million in total. (Aurelius does not disclose its holdings or discuss its trading.) If Aurelius purchased those bonds at 50 cents and then sued for the full face value, that difference could yield a profit of 100 percent, before legal costs. Now imagine purchasing the bonds at a steeper discount — 35 cents on the dollar, or 25.

Puerto Rican debt would have looked attractive for two reasons. Having poor credit, the island paid much higher interest than other government borrowers, about 8 percent versus the 4 percent that New York City, for example, paid for bonds issued during the same period. And, Puerto Rican bonds trade on the United States municipal market, but, unlike a city, Puerto Rico could never declare bankruptcy. Federal law forbade it. One way or another, the island would have to find a way to pay its debts. Unless someone changed the law.

Though vulture funds have a reputation as calculating mercenaries who can see 10 steps ahead, they are in fact much closer to trial lawyers who adjust their tactics in real time to accommodate new evidence or parry changes in the opposing team’s strategy. It’s misleading to speak of a singular distressed-debt strategy. The strategy is to outfox and improvise. Accordingly, the best sovereign-debt hedge funds are run by scrappy types with experience in courtrooms, not business-school graduates or management consultants. Paul Singer, the litigant behind the Argentine frigate affair and the man Brodsky considers his mentor on Wall Street, once told an interviewer that his boyhood ambition was becoming “a courtroom lawyer, someone like Perry Mason.” Like Singer, Brodsky practiced law before defecting to finance.

In June 2016, President Obama signed the law that allowed Puerto Rico to declare bankruptcy: The Puerto Rico Oversight, Management and Economic Stability Act, panderingly named to generate an acronym in Spanish. PROMESA was a unique piece of legislation. It passed with bipartisan support during a period when nearly nothing else did. And it is vehemently loathed by nearly everyone it affects. PROMESA let the island restructure its debt, but — critics have suggested — at the cost of its sovereignty. To supervise Puerto Rico’s finances, the law created a panel of seven people, which came to include an insurance executive, a bank chief executive and a private-equity manager. Where before the island’s governor and representatives decided what to spend money on, now an unelected board would have veto power over the budget.

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