If there’s one country that pretty much set the entire playbook for vulture funds, it’s Peru. It has defaulted on many different debts at various times in its history, while at the same time being rich enough to pay back those debts in full if it wanted to. That combination is catnip to U.S.-based hedge funds, which love nothing more than to buy up debts at pennies on the dollar, and then agitate to get repaid in full.
Now, once again, Peru is facing off against a giant U.S. vulture fund, as funds that employ such strategies are known. Except this time, Peru has a brand-new president who cut his teeth as a banker on Wall Street and knows all the rules of the game.
So the stage set for a heavyweight fight between a multi-billion dollar American vulture fund and a financially savvy president with full sovereign might on the other. Historically, vulture funds in Latin America have done best when they faced off against populist leftist leaders who don’t respect the power and complexity of international law. So while they are happy to be dealing with a center-right financier in Peru, they are also now dealing with the wiliest opponent possible. The problem for Peru's new president-elect is that his predecessors have left him in a serious pickles.
Pedro-Pablo Kuczynski, who this week defeated presidential challenger Keiko Fujimori by a razor-thin margin, knows the world of finance intimately. He was chairman of First Boston for a decade, and later ran his own U.S.-based private equity fund focusing on Latin America. He’s also been active in Peruvian politics since the 1960s, when he fled his job at Peru's Central Bank after the military dictator Juan Velasco came to power.
One of Velasco’s signature policies was land reform. He seized land from the relatively rich families that owned it and distributing it to peasant cooperatives. The families weren’t paid in cash, but given bonds that were meant to reimburse them for their loss of land over a period of 20 to 30 years.
The state eventually defaulted on its land-bond obligations and the families were left with seemingly worthless paper. By the mid-2000s, decades after the default, it was abundantly clear that the government had no intention of ever paying them, so many families sold their bonds at extremely low prices.
Enter the vultures.
Starting in 2006, Gramercy Advisors, a Connecticut hedge fund, quietly started approaching Peru’s richer families and offered to buy up their bonds. Over the next two years, the fund managed to accumulate an enormous position in these certificates – some 9,773 separate bonds, which Gramercy claims are today worth some $1.6 billion. Needless to say, that’s vastly more than Gramercy paid the original bondholders. And if Gramercy ever does get paid out on this paper, it will keep all of the profits, sharing none of them with the Peruvian families whose lands were confiscated.
Still, getting paid isn’t easy. The land bonds were issued under Peruvian law, and denominated in a currency that later became worthless due to hyperinflation. The result is that even if bondholders can persuade Peruvian courts that they should get paid a certain amount, the government can always just change the law to ensure that they don’t get paid.
As a result, vultures tend to prefer foreign-law debt issued in foreign currency. The world’s most notorious vulture fund, Elliott Associates, bought $20 million of Peruvian loans at a steep discount in 1996 and then refused to tender those loans into a restructuring deal. Instead, Elliott sued Peru in courts around the world. Then Elliott got really lucky when it received a series of positive court rulings in 2000, just before then-president Alberto Fujimori resigned from his position via a fax sent from Japan, in the midst of a major corruption scandal. With all the domestic political chaos, the Peruvian government had little ability to continue to fight Elliott in numerous international courts, and ended up paying the vultures some $56 million in cash. Similarly, Elliott’s much bigger fight against Argentina was a fight over dollar-denominated bonds issued under New York law.
Suing a country isn’t easy. No court is going to send in gunships to force a sovereign nation to pay its debts. And so long as the country in question keeps its technocratic wits about it, it can generally manage to avoid paying its litigious creditor. The trick for indebted governments is to stay calm, and, like Hippocrates, first do no harm. But that’s easier said than done, especially in Latin America.
In Argentina, for instance, the Kirchner administration’s antipathy to the vulture funds caused them to do things like pass a “lock law” and otherwise needlessly antagonize Thomas Griesa, the American judge overseeing the case. Eventually, he got so angry and upset by Argentina’s attitude that he handed down an unprecedented judgment, which effectively barred Argentina from paying any of its other creditors unless and until they paid Elliott first. That (along with a new presidential election) did the trick, and Elliott was paid off.
Similarly, in Peru, if the country had simply continued to ignore various court judgments telling it to pay the land bonds, there’s very little the Peruvian courts could really have done to force the government’s hand. The president’s the president, and if the president doesn’t want to pay, he won’t.
Yet Peru's former leftist president Ollanta Humala went way too far and made a big mistake. In 2013 he interfered with a crucial ruling from the country’s highest court, forging the signature of one of the judges and turning what was originally meant to be a ruling into a mere dissent. That kind of shenanigans is hardly unheard-of in Latin America, but with the fraud came a new opportunity for Gramercy, which has now found a way to bring in foreign courts. Specifically, Gramercy claims that Humala’s actions in 2013 violated a U.S.-Peru trade pact, wherein Peru promised not to behave in such an unjustifiable and arbitrary manner towards American investors like Gramercy.
By seizing on Peru’s 2013 actions now, just before the three-year statute of limitations expires, Gramercy has cleverly upped the stakes. Trade-pact arbitration takes a very long time, but any final award has the power of a treaty obligation to the World Bank, a much higher-priority debt than some long-defaulted local-law land bonds. Peru would probably end up paying such a demand. But doing so would be politically poisonous, since the foreign vulture fund would be the only winner, and Peruvians who still hold land bonds would get nothing.
The result is that Kuczynski has inherited a very hot potato indeed. If it weren’t for his predecessor trying to meddle with the domestic Peruvian courts, the urbane new president could surely manage the Gramercy problem quite easily. Of all the priorities that Peru can spend billions of dollars on, paying off a foreign vulture fund is surely very near the bottom of the list, and Kuczynski has decades of experience dealing with aggressive financiers.
Now, however, the clock is ticking. Gramercy is upping the pressure by taking another page out of the Elliott playbook and setting up a Washington-based lobbying organization to try to court anybody important in the U.S. Elliott’s shop in the Argentina case was called American Task Force Argentina; Gramercy’s Peruvian equivalent is called Peruvian-American Bondholders for Justice. PABJ has done a pretty good job so far of exploiting the Humala administration’s lack of sophistication in Washington, but Kuczynski is a far more formidable opponent.
In other words, the fight is on. Kuczynski has no good reason to pay Gramercy billions of dollars, and neither does he want to throw a huge sum of money at Peru’s richest families (the ones with land bonds). But he also can’t simply ignore the issue and leave it to his successor. Most likely, the Kuczynski administration will make quiet overtures to Gramercy, while fighting and delaying any international tribunal hearing as aggressively as it can.
The good news for Peru is that it could not hope to have a stronger or more sophisticated negotiator in charge of this problem. The main lesson from Argentina – and indeed from earlier Peru cases – is that an aggressive frontal assault on vultures is generally not a good idea. Kuczynski is a center-right politician, and he might end up paying the land bond holders something. If he does, he’ll open himself up to obvious attack from the left, which backed his campaign. But putting this issue quietly to bed might, in the long run, be a lot cheaper for Peru than running the risk of a nasty ruling from a World Bank tribunal.