On September 23, 2010, the U.S. Court of Appeals for the Second Circuit upheld an annual interest rate of 101% (based on an interest rate formula) owed on Argentine government bonds. Argentina had attacked the enforceability of the interest provision, arguing it was unenforceable as a penalty, substantively unconscionable or void as usurious. The Second Circuit, however, rejected Argentina's arguments. NML Capital Ltd. v. Argentina, No. 09-2707, slip op. at 1 (2d Cir. Sep. 23, 2010). The court also considered whether statutory interest should accrue on unpaid bond interest after maturity and after acceleration, and it formally requested that the New York Court of Appeals consider the statutory interest issues. Id. at 28-30.


In 1998, the Republic of Argentina issued securities known as "Floating Rate Accrual Notes" ("FRANs"). Id. at 4. The plaintiffs purchased the FRANs on the secondary market after Argentina's 2001 financial collapse and, in the case of certain of the plaintiffs, after the April 2005 stated maturity date. Id.

The Certificate evidencing the FRANs required the payment of interest every six months in arrears on April 10 and October 10 "in each year ... until the principal hereof is paid or made available for payment." Id. at 4-5. The Certificate required Morgan Stanley, as the Determination Agent, to calculate the interest rate for each six-month period according to a formula "based on the yields to maturity of other Argentine-issued debt." Id. at 5. Events of default under the Fiscal Agency Agreement (the "FAA") included the failure to pay any principal of or interest on the FRANs or the declaration of a moratorium on the payment of principal of or interest on any external debt of Argentina. Id. at 5-6. The FAA provided that upon the occurrence of an event of default, the registered holders of FRANs may accelerate the principal of their notes. Id. at 6.

In December 2001, after a severe economic crisis, Argentina declared that it would "no longer service its approximately $80 billion in external debt." Id. As a result, the yield to maturity on the Argentine-issued debt used by the Determination Agent to calculate interest pursuant to the FAA increased, Accordingly, the interest rates for the FRANs also increased. Id. at 6-7. The interest rates rose from between 9% to 14.4% per annum prior to October 2001, to 101.052% by their April 2005 maturity date. Id. at 7. Because the moratorium constituted an event of default, the plaintiffs accelerated the principal of their FRANs. Id.

Procedural History

The noteholders sued Argentina for its failure to pay principal and interest under the FRANs. Id. The Southern District of New York granted the noteholders summary judgment as to Argentina's liability under the FRANs and directed the parties to confer to determine the exact amount in which final judgment should be entered. Id. at 8.

The noteholders sought interest at a per annum rate of 101.052% for the payment period ending on April 9, 2005. Id. In addition, the noteholders sought to collect further interest at the 9% statutory rate for all interest payments — whether due prior to or after acceleration or maturity — that Argentina had failed to make. Id.

On March 18, 2009, the District Court found that the interest rate was not an unreasonable penalty, unconscionable or in violation of New York usury law. Id. at 8-9. After requesting additional proposed final judgments from the parties, on May 29, 2009, the district court found that the noteholders were also entitled to statutory interest on unpaid interest payments. Id. at 10.

Second Circuit: No Reformation of the Notes

The Second Circuit refused to rewrite the interest rate provision in the FRANs. It found that the interest rate provision did not constitute an unenforceable penalty, create an unconscionable result, or violate public policy so as to warrant reformation.

Unenforceable Penalty. First, the Second Circuit found that since the interest rate provision did not amount to a damages provision for violating the bond documents, it was not a penalty. Id. at 12. The debt moratorium caused the yield to maturity on other Argentine bonds to increase. Id. Although the moratorium constituted an event of default under the documents governing the FRANs, it only indirectly increased the interest rate on the FRANs. As the court noted, the moratorium "did not alter the formula outlined in the rate provision. Accordingly, the resulting interest rates cannot be deemed 'default interest rates.'" Id. at 13. Therefore, the interest rate provision was not a liquidated damages clause subject to review as a potentially excessive penalty.

Unconscionability. Second, the Second Circuit found the doctrine of unconscionability to be inapplicable. Id. Argentina argued that the rate provision "produced post-default interest rates so grossly unreasonable and unfair to [Argentina] as to render it substantively unconscionable and thus unenforceable under New York law." Id. The doctrine of unconscionability originally arose in the context of consumer law. It "seeks to prevent sophisticated parties with grossly unequal bargaining power from taking advantage of less sophisticated parties." Id. at 14. The court noted that "the process leading to the execution of the bond documents was not flawed". Id. In fact, "given ... the knowledge that sophisticated parties like Argentina and the prominent New York City law firm representing it presumably possessed regarding the impact of a sovereign's impaired creditworthiness on its bonds' yields to maturity, Argentina can hardly profess surprise or prejudice at the consequences of its decision to discontinue paying any principal or interest on its external debt." Id. at 15.

Usury. Third, the Second Circuit found that since New York's usury laws are "expressly inapplicable where the sum involved is equal to or greater than $2.5 million," usury laws provided no basis for attacking the enforceability of the interest provisions. Id. at 16. The court refused to entertain Argentina's argument that though technically inapplicable, "the district court should have considered the law in determining whether the interest rate provision was enforceable." Id. at 16-17. The court concluded: "Given the text of § 5-501(6)(b) of the General Obligations Law and the case law construing it, we cannot conclude that the legislature's intent was anything other than to permit parties negotiating the terms applicable to the borrowing and repayment of sums of $2.5 million or more to choose to incorporate interest rates higher than 25%." Id. at 17.

Statutory Interest

The Second Circuit also addressed the interpretation of provisions of the N.Y. C.P.L.R. § 5001(a) that provide for statutory interest on interest payments. The statute is not clear, however, about whether such interest will accrue on interest payments that may have arisen after the maturity date. Id. at 21. Here, the FRANs matured on April 10, 2005; at least one plaintiff accelerated the principal of its FRANs. The Second Circuit concluded that whether the New York statute entitled the noteholders to receive interest on interest payments that would have been payable every six months should be decided by the New York Court of Appeals. Id. at 25.


1. The Second Circuit's opinion provides some reassurance to alternative lenders that extend "expensive" loans to risky borrowers. Lenders should find some comfort in the court's insistence that the parties should be held to the written contract and its rejection of Argentina's arguments that the interest rate provisions should be rewritten.

The approach of the Second Circuit contrasts favorably with Judge Rakoff's order in Empresas Cablevisión, S.A.B. de C.V. v. JP Morgan Chase Bank, N.A., 680 F.Supp.2d 625 (S.D.N.Y. 2010). In the Empresas Cablevisión case, the credit agreement granted the borrower no consent rights with respect to sales by lenders of participation interests in their loans. Judge Rakoff held that even though no provision granted the borrower any approval rights with respect to acceptable participants, a lender should be enjoined from selling a participation interest in a loan to a Mexican bank that was affiliated with a competitor of the borrower. Judge Rakoff wrote that the participation sale violated the selling lender's "covenant of good and fair dealing."

2. The NML Capital opinion suggests that a default interest rate provision would need to be analyzed to confirm whether it constitutes a reasonable calculation of liquidated damages or a penalty. Customary default interest provisions are triggered by the occurrence of an event of default. Generally, increases of two percent above the otherwise applicable interest rate have been held enforceable. Increases in excess of two percent that are triggered by an event of default should be evaluated under the traditional liquidated damages test (reasonable estimate of damages versus penalty). The Second Circuit concluded that such an analysis of the FRANs interest rate provision was not necessary, because the event of default resulting from the debt moratorium did not directly increase the interest rate provided for in the FRANs.

3. A bankruptcy judge may have different views about whether a very high interest rate constitutes a penalty. Bankruptcy courts are courts of equity. It is possible that faced with requiring a debtor to pay a creditor an amount of interest that might be viewed as excessive versus employees, retirees and vendors, a bankruptcy judge might reach a different outcome.

To read the Second Circuit decision, please click here.