NML Capital v. Republic of Argentina
2010 U.S. App. LEXIS 19916, 2010 WL 3704570, 621 F.3d 230 (2010)
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Rule of Law:
A variable interest rate provision in a bond agreement, tied to the issuer's own creditworthiness, is an enforceable mechanism for compensating lenders for risk and does not constitute an unenforceable penalty, nor is it unconscionable or void as against public policy when negotiated between sophisticated parties.
Facts:
- In 1998, the Republic of Argentina issued a series of securities known as Floating Rate Accrual Notes (FRANs) to raise capital.
- The interest rate on the FRANs was not fixed; it was calculated based on the yields of other Argentine-issued debt, meaning the rate would rise if Argentina's perceived credit risk increased.
- The bond documents specified that Argentina would pay interest semi-annually 'until the principal hereof is paid or made available for payment.'
- NML Capital and other plaintiffs purchased beneficial interests in these FRANs, some doing so after Argentina's financial situation had deteriorated.
- In December 2001, facing a severe economic crisis, Argentina announced a moratorium on servicing its external public debt, including the FRANs.
- This announcement constituted an 'event of default' under the bond agreements, giving bondholders the right to accelerate the principal.
- As a direct consequence of Argentina's deteriorating creditworthiness following the default, the contractually calculated interest rate on the FRANs surged, eventually exceeding 100% per annum by the maturity date in 2005.
- Argentina failed to pay the principal or the accrued high-rate interest to the plaintiff bondholders.
Procedural Posture:
- Plaintiffs, including NML Capital, filed a series of lawsuits against the Republic of Argentina in the U.S. District Court for the Southern District of New York for failure to pay principal and interest on the FRANs.
- The district court granted summary judgment to the plaintiffs on the issue of Argentina's liability.
- Plaintiffs then moved for partial summary judgment to determine the amount of damages, specifically seeking enforcement of the floating interest rate.
- Argentina opposed the motion, arguing for reformation of the interest rate provision on the grounds that it was an unenforceable penalty, unconscionable, and violated public policy.
- The district court granted plaintiffs' motion in part, rejecting all of Argentina's defenses to the enforceability of the contract's interest rate provision.
- After the district court entered final judgments in favor of the plaintiffs, Argentina appealed to the U.S. Court of Appeals for the Second Circuit.
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Issue:
Is a floating interest rate provision in a sovereign bond, which is tied to the issuer's own creditworthiness and results in a dramatically increased interest rate upon the issuer's default, an unenforceable penalty, substantively unconscionable, or void as against public policy under New York law?
Opinions:
Majority - Judge Reena Raggi
No. The floating interest rate provision is an enforceable part of the contract and is not an unenforceable penalty, unconscionable, or void as against public policy. The court reasoned that the provision was not a liquidated damages clause triggered by a breach, but rather a mechanism to determine compensation for the use of principal that adjusted based on market risk. The interest rate would have increased due to Argentina's moratorium on other debt even if it had continued paying the FRANs, proving the rate was tied to creditworthiness, not breach. The court rejected the unconscionability argument because Argentina was a sophisticated party that drafted the terms and the risk of default was explicitly contemplated in the agreement; it was a bargained-for allocation of risk, not an unfair surprise. Finally, the provision did not violate public policy against usury because New York law expressly exempts transactions over $2.5 million from its criminal usury statutes.
Analysis:
This decision reinforces the strong judicial deference to freedom of contract between sophisticated commercial parties under New York law. It clarifies that a contractual interest rate tied to the borrower's own credit risk is a valid risk-allocation tool, not a penalty for default. The ruling makes it exceptionally difficult for sophisticated entities, such as sovereign nations or large corporations, to escape contractual obligations by claiming unconscionability, especially when the supposedly unfair outcome resulted from risks that were foreseeable and explicitly addressed in the contract. This solidifies the principle that courts will not disturb the allocation of risk negotiated by parties with comparable bargaining power.
