Hedge funds and other investment funds are emerging as sophisticated litigators, viewing litigation as an asset, which can create value and mitigate risk, rather than something to be avoided or feared. As a consequence, both the market and various legal systems are being disciplined and developed.
How and why is this happening?
Willing to litigate relentlessly and fearlessly, hedge funds will seek out and find gaps in documents and uncertainties in the law, and exploit them with ruthless efficiency, entering new legal territory and pushing the boundary of legal theories.
The effect is to discipline the market. Defaulting corporates are being held accountable by litigation; challenges through litigation and investment treaty arbitration to wrongful acts of states, provide an important check and balance against the creep of expropriation; directors and insolvency administrators are forced to focus carefully on their duties, where there is a litigious hedge fund creditor base.
Hedge funds’ use of litigation rights as an asset derives from the distressed debt markets, notably including: the Icelandic banking crisis; Argentinian state debt default; and Elektrim’s bond restructuring (Polish conglomerate).
“Not only were the hedge funds asking the Icelandic Courts to undo legislation applied by their home state, but they were also seeking to do so, on the basis that hedge funds should have the benefit of ‘human rights’.”
In 2008, the Icelandic economy collapsed, both driven by and causing the collapse of Iceland’s three largest banks; Kaupthing, Glitnir, and Landsbanki. Taken together, it was the second largest insolvency in the world.
In the 48 hours before these banks entered insolvency, and overnight, emergency legislation was passed retroactively prioritizing deposits ahead of other unsecured debt (including notes and loans held by financial institutions). The effect was that holders of this debt went to bed ranking pari passu with depositors and woke up subordinated to them. When the banks filed for insolvency shortly thereafter, their anticipated recoveries were drastically reduced.
Originally the bond and loan debt was held by institutional investors such as pension companies and insurance funds. However, these institutions were able to liquidate their investments by selling them at a deep discount. Their debt was purchased by hedge funds with a view to creating value through, amongst other things, litigation.
As sophisticated and experienced litigators, the hedge funds took early steps to reserve rights to litigate and challenge the actions of the Icelandic State (in passing the overnight ‘emergency’ litigation) and the insolvency administrators. In turn, this entitlement to future potential litigation added value, with a micro-market springing up allowing the trading of claims in the insolvent banks with the price being raised by this litigation entitlement.
To maintain the value that litigation entitlement had created, the hedge funds then pursued unprecedented litigation, challenging the legislation that had subordinated their debt and the application of that legislation in the insolvency proceedings of the three banks. The litigation was complex—the hedge funds were asking the Icelandic Courts to overturn legislation passed by the Icelandic State on the basis that it amounted to a wrongful expropriation of property without compensation. The legal basis of this claim was rights set out in the European Convention of Human Rights, which had been enshrined in the Icelandic Constitution. Not only were the hedge funds asking the Icelandic Courts to undo legislation applied by their home state, but they were also seeking to do so, on the basis that hedge funds should have the benefit of ‘human rights’.
While an appeal right to the European Court of Human Rights was never ultimately pursued, throughout its life the litigation created leverage and value for the hedge funds and arguably put a check and balance on the Icelandic State and the insolvency administrators, preventing further expropriation and negative actions while that risk remained. Since the completion of the litigation, several institutions traded out of the debt, and it could be argued that this check and balance has fallen away and the creep of expropriation has returned.
Litigation rights enabled the hedge funds to gain financial advantage by being ahead of the market in terms of the value and timing of the litigation, and it also added value in the insolvency proceedings themselves as it disciplined the Icelandic State and the insolvency administrators by adding scrutiny and oversight.
Testing novel points of law within the framework of a creative legal strategy helps to develop the law and bring certainty to markets. For market participants, this provides accountability and regulation. For hedge funds, it provides value.
Featured image: ‘Hedge’ by Levent Ali. CC-BY-ND-2.0 via Flickr.