The emergence of “activist” investors across a range of markets has been one of the most interesting phenomena of the past few decades (see here, here and here). These investment funds seek to capture rents from their investments by “actively” enforcing their rights.  Activist investors pursue this strategy in markets in which the majority of investors are passive. Much of the discussion of this development in both the financial press and the academic literature has focused on activists acquiring equity positions in order to influence a firm’s management policies (see here and here). Our focus, however, is on debt markets, and specifically sovereign debt.  In this context, activist investors purchase the debt of a distressed sovereign that is attempting to restructure its obligations with its creditors with the aim of capturing rents by holding out from the restructured deal (see here).

If the sovereign does not pay a sufficient premium to the holdout, the holdout’s strategy is to litigate, not only against the sovereign but potentially as well against the other creditors who accepted the restructuring deal.  This strategy creates leverage over the other players in sovereign debt negotiations because the holdout—unlike its passive counterparts—invests in analyzing the contract terms of sovereign bonds and developing a strategy to litigate these terms in court.  This investment sometimes pays off and allows the activist creditor to advance legal challenges sufficient to induce the sovereign—who is otherwise immune from bankruptcy proceedings—to settle the holdout’s claim.

In contrast to the holdout creditors, most investors in government debt markets tend to be bovine. Rather than seek the best possible contract terms among the array of different debt obligations available on the market, passive investors are content to buy debt obligations that use the “standard form”—even if it contains ancient boilerplate whose meaning may be vague and unclear. The presence of these “black holes” in the standard form, together with other seemingly minor differences in enforcement rights, provide the opportunity for the holdout to enforce their contract rights in ways that the passive creditors failed to appreciate at the time they purchased the debt.

This strategy famously played out in the decade-long saga of billionaire Paul Singer’s hedge fund chasing after Argentinian assets following that country’s default on its sovereign debt.  The contract clause at the center of the NML Capital v. Argentina litigation—the pari passu clause—was in almost every sovereign bond, but almost no one understood it (for much more, see here and here). The ambiguity over the meaning of pari passu gave Singer’s lawyers a pathway to argue (successfully) for a meaning of the ubiquitous clause that led to hundreds of millions of dollars in profits for  Singer’s fund (see here).

The question at the heart of our paper, “Hidden Holdouts: Contract Arbitrageurs and the Pricing of Collective Rights,” is whether the rents that activists like Singer’s fund are able to capture in this market are nevertheless welfare enhancing:  Does the holdout’s self-interested effort to uncover differences in the enforcement rights in sovereign bond contracts lead to more efficient pricing of debt obligations?  One perspective on activists’ arbitrage efforts is to focus on the regressive wealth transfer away from the citizens of a country struggling to pay its foreign debts to wealthy hedge fund managers. This perception of the activists as vultures seeking to benefit from the ignorance of passive investors and thereby contribute to the hardship facing the sovereign’s citizens frequently leads to calls for regulation to constrain their behavior.

We understand this perspective, but from another point of view this vilification of market actors who carefully read and aggressively enforce their contract rights—while the majority of the market ignores the enforcement rights in the documentation—is upside down. After all, accurate market pricing, which leads to a more efficient allocation of investments and a reduction in fraud, will occur only if some subset of investors expend resources to understand and enforce their contract rights. And those investors will invest those resources only if there are financial gains to be made from the arbitrage activity of analyzing the contract terms and then enforcing the debt contracts by using novel legal arguments based on that investment. By reading contracts that no one else reads and enforcing contract rights that many don’t even know that they have, activists require others in the market to pay attention to contract language and price it properly.

But is this how things work in practice?  Do holdout investors actually generate more accurate pricing of contract rights—at least the rights that enable the holdouts to play their game?

To analyze this question, we use the data from the ongoing Venezuelan sovereign debt crisis. Venezuela has been in an economic crisis since at least 2014.  Its external financial obligations are likely more than $150 billion, while its revenues from its primary asset, oil, have been dropping. Relevant for our purposes are three key facts:

• Venezuela’s debt stock has variations in contract terms that are rarely found in countries in deep distress.
• There are contract differences among the Venezuelan bonds that are better or worse positions for a holdout creditor.
• Venezuela is almost completely dependent for foreign revenues on the sale of a single asset, oil, to a variety of foreign jurisdictions (such as the U.S.), where creditors can seize those assets to satisfy unpaid bills.

Conventional theory predicts that, as Venezuela gets deeper into crisis and nears default, specialist holdouts such as Singer’s fund will begin to purchase bonds that they have identified as having better legal terms. That market activity, in turn, should produce an increase in the prices of bonds that are identical in all respects other than these holdout-friendly terms.  Indeed, the more activist investors that are present, searching for contract arbitrages, the more incentive for even the bovine investors to start analyzing their contracts since they know that the arbitrageurs will pay more for the holdout-friendly bonds. Ultimately, when this happens, the market will price the difference in contract terms efficiently.

In our paper, we identify a set of three contract terms, each of which is contained in a different subset of Venezuelan bonds, that can be ranked against each other as to whether the bond in question is more or less holdout friendly. The prediction is simple:  If the theory about specialist holdouts facilitating price revelation is correct, we should see that the three contract differences that matter to the holdouts are revealed to the market as the sovereign gets closer to crisis.

Our examination of the data from 2014-18 shows zero support for the prediction that holdout creditors facilitate price revelation. The prices of the bonds that should be more attractive to a holdout are essentially the same as those that should be less attractive to these holdouts.  Put differently, the prospect of holdouts enforcing certain contract rights does not seem to translate into pricing differences.

Why not?  Our conjecture is that this pricing puzzle is a product of the way in which holdouts make their profits from sovereign restructurings. Holdouts can capture rents only if the passive creditors quickly agree to restructure on reasonable terms so that the activist is then able to sue and threaten to disrupt the sovereign’s attempt to rehabilitate. But holding out is a costly and risky strategy. Not only is purchasing a blocking position costly, but so too is acquiring the legal expertise to successfully sue the sovereign and induce a settlement. That means that the holdouts have an incentive to keep secret which bonds they plan to target. After all, the more the passive creditors can buy into the bond the activists are targeting, the less likely it is that the holdout strategy will succeed (if there are too many holdouts, the holdout strategy fails, because there is no restructuring deal to hold out on).

To test our conjecture, we searched for instances where rumors had leaked about which Venezuelan bonds the holdouts were targeting (see here and here).  If we are right about the hidden-holdout phenomenon, then it is only where there are sufficiently solid rumors of holdout activity that we should see differentials in bond prices as a function of the holdout-friendly contract terms.  And that is what we see.

The deeper story here, we believe, has to do with the difference between contract rights that are collective and ones that are not. When the enforcement of a contract right depends on the actions of others, and the interests of those others are divergent, it is difficult to predict how the others will act.  And that is particularly so if one is dependent on the actions of others who affirmatively seek to hide their plans. This presents the market with a substantial collective action problem. Holdout creditors thrive when they can build blocking positions against bond restructurings.  But they don’t want other creditors to know which bonds they are targeting. The result:  Price revelation does not occur, except when the information on the holdout’s plan leaks. Now, this does not mean that holdouts aren’t adding value by imposing market discipline in some other fashion; higher liquidity perhaps?  But enabling price revelation does not look to be the pathway.

This post comes to us from professors Robert E. Scott at Columbia Law School, G. Mitu Gulati at Duke Law School, and Stephen J. Choi at New York University Law School. It is based on their recent paper, “Hidden Holdouts: Contract Arbitrageurs and the Pricing of Collective Rights,” available here.