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Marblegate and the Use of Exit Consents to Restructure (Venezuelan) Sovereign Debt

posted by Mark Weidemaier

This is a joint post by Mark Weidemaier and Mitu Gulati.

About a decade and a half ago, exit consents were a big deal in sovereign debt restructuring. At the time, sovereign bonds governed by New York law required unanimous bondholder approval before any modification to the payment terms of the bonds. The result was that creditors could easily hold out from a restructuring. Needing to mitigate the holdout problem in Ecuador in 2000, sovereign debt guru Lee Buchheit borrowed a technique from corporate bond restructuring practice in the United States. There, the Trust Indenture Act forbids out-of-court bond exchanges that modify "the right of any holder ... to receive payment ... or to institute suit" without the consent of each affected bondholder. To oversimplify, Buchheit leveraged the fact that other terms of the bonds could be amended with a lesser vote, often a simple majority or 66.67% of the bonds. This meant that potential holdouts risked having key protections stripped from their bonds in a restructuring that won the approval of a majority of bondholders.

Ecuador used this exit consent technique in 2000, as did Uruguay in 2003 and the Dominican Republic in 2006. Yet later developments seemed to relegate exit consents to the historical dustbin. First, virtually all foreign-law sovereign bonds issued after 2003 included collective action clauses (CACs), which allowed a super-majority of bondholders to modify even payment terms. Second, a number of judicial opinions appeared to rein in the use of exit consents, viewing the technique as potentially coercive. Thus, after a key English case, Anna Gelpern queried: "Exit Consents Killed in England?"

Recent cases pending before federal courts in New York raised the possibility that the exit consent technique would be limited even further. About a month ago, the Second Circuit issued an opinion in one of these cases: Marblegate. The case has attracted a lot of attention, and the Wall Street Journal and Financial Times have good background. In a nutshell, the issue in Marblegate was whether a bond exchange can be so coercive that it functionally impairs the right "to receive payment ... or to institute suit," even though, as a formal matter, the exchange leaves those rights intact. 

Marblegate implies that the answer is "no," although the court did not say this in such explicit terms. It did, however, interpret the TIA's prohibition as limited to "formal indenture amendments to core payment terms" (and modifications that prevent bondholders from "initiating suit"). If taken literally, this view gives issuers a great deal of freedom to play hardball in structuring a bond exchange. The issuers most likely to value this freedom are sovereign governments (e.g., Venezuela) and their instrumentalities (e.g., PDVSA). 

Venezuela's bonds are not subject to the TIA (and do not even involve a trust indenture). Nevertheless, some of its older bonds require the consent of each bondholder to modify core payment terms (and a few other terms, which we'll call "Reserved Matters"). The bonds thus replicate the TIA's prohibition, but as a matter of contract rather than statute. Moreover, while Venezuela's newer bonds have collective action clauses allowing holders of a super-majority of the outstanding debt (either 75% or 85%) to impose restructuring terms on dissenters, these CACs operate series-by-series, which makes it relatively easy for dissenters to block a restructuring vote. All Venezuelan bonds, however, allow modifications to non-Reserved Matters at a lower voting threshold. In any Venezuelan restructuring, then, exit consents will likely play a prominent role, given the country's inability to rely on CACs. As noted earlier, in 2000 Ecuador conducted an exchange in which participating bondholders voted to remove cross-default and negative pledge clauses, and to delist the old bonds. (Venezuela's case is complicated by the fact that its newer bonds expand the list of Reserved Matters to require super-majority approval to change some non-payment terms, such as clauses specifying the governing law.) Although instrumentalities such as PDVSA sometimes issue debt with CACs, PDVSA's bonds likewise incorporate the TIA's prohibition, requiring each bondholder to consent to any modification that impairs the right "to receive payment ... or to institute suit." Thus, it too may turn to exit consents as a restructuring tool.

The question is what lessons Marblegate teaches about the use of exit consents in the context of bonds issued by foreign governments and their instrumentalities. The TIA imposes no limits whatsoever on Venezuela's use of exit consents. Those limits, whatever they are, stem from the bond contract and from New York law (which governs the bonds). Our sense, however, is that a foreign sovereign should have more rather than less freedom to use exit consents, even if it presents bondholders with a choice that is somewhat coercive. After all, in the domestic corporate debt context, the alternative to exit consents is bankruptcy. The TIA represents a policy in favor of conducting collectively-binding workouts under the supervision of a bankruptcy court. But of course there is no bankruptcy fallback for sovereigns. If a sovereign is to implement a collectively-binding restructuring, contractual tools are its only option. We don't doubt that New York law imposes some limits on the ability to conduct a coercive debt exchange--whether under the duty of good faith or under some other doctrine--but we do not see why those limits should be more draconian than those imposed by the TIA.

For PDVSA the question is a bit more complicated. Whether or not it was required to comply with the TIA (section 304 exempts securities "issued or guaranteed by a foreign government or ... instrumentality thereof," though we gather that some lawyers interpret this exemption narrowly), PDVSA incorporated the TIA's precise language into its bonds. Thus, in examining the legality of any PDVSA exchange offer, one might expect a court to look to Marblegate for guidance. The Second Circuit's reasoning may not prove very helpful, as the court based its ruling on an extensive inquiry into the TIA's legislative history. To the extent the limits on PDVSA's right to conduct exchange offers stem from contract law, discussion of the TIA's legislative history isn't all that relevant. But the result in Marblegate certainly suggests PDVSA will have substantial freedom to conduct a debt exchange, so long as it does not amend "core payment rights" or bar bondholders from "initiating suit." It does not take too much imagination to envision an exchange offer that forces PDVSA bondholders to choose between (a) accepting new bonds with less favorable payment terms and (b) retaining old bonds that have been stripped of many of their protections and that represent claims against an entity that has been stripped of its right to exploit Venezuela's oil reserves. While not exactly an appealing choice, we suspect many bondholders would agree to restructure.

In any event, Marblegate is not the last word on these questions. It was a 2-1 decision, with a robust dissent. Other cases will shed further light on the utility of the exit consent technique. But for now, sovereign borrowers and their financial advisors may be breathing a sigh of relief.

Comments

The key question does indeed seem to be that of how precedential Marblegate really is? In addition to the statute versus contract matter, and that lack of bankruptcy in the sovereign context (and maybe (arguably) the PDVSA context too) this is a contract under state law and the Second Circuit is a federal court. Are there older state law cases here that might be relevant?

Katz v. Oak Industries, the classic Chancellor Allen opinion, had much more of a contract-type analysis. So much of Marblegate was about parsing a highly ambiguous legislative history.

Marketable nature of bonds requires uniformity of interpretation in terms of market efficiency. Thus, courts tend to focus on expressed term of indentures and are reluctant to find implied duties. Metropolitan Life Insurance Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504, 1509 (S.D.N.Y. 1989) (citing Sharon Steel Corp. v. Chase Manhattan Bank, N.A., 691 F.2d 1039 (2d Cir. 1982)). In Katz v. Oak Industries, Inc., likewise, the court tested whether the indenture provisions expressly prohibit offering an inducement to bondholders to consent to such amendments.

I believe, however, that such requirement for “expressed” agreement cannot be dispositive as to how the language “impair the right … to receive payment … or to institute suit” (“impairment language”) would be construed in bond indenture context. One possible interpretation would be that the indenture separately requires unanimous consent on any amendments that “reduce the rate of … or extend the time for payment of interest” or “reduce the principal … change the principal installment … change the fixed final maturity” and, if the parties only intended to restrict the “formal indenture amendments to core payment terms," the impairment language was not necessary, so the impairment language expresses that "something more" requires unanimous consent. Another possible interpretation is: the impairment language’s striking resemblance to TIA expresses that the parties intended to restrict what is restricted under the TIA (they just wanted to incorporate the same restriction with TIA’s one into the indenture) and, in Katz and some precedents following it, no bondholders even insisted that exit consent violates the TIA, which expresses the market’s understanding that impairment language does not restrict the exit consent.

It is difficult for me to tell which interpretation (or any other) should prevail, but the situation seems similar to pari passu discussion, in that one can argue that “ranking” interpretation is meaningful in liquidation, which is not available to sovereign, so pari passu should mean something more, and another can argue that pari passu has established interpretation in corporate context and the parties just followed that practice. Pari pass does not replicate the language of laws, but I found some similarity in that there could be different approach in interpreting contractual clause: expressed language should be given some meaningful construction, or market practice should be followed in contractual interpretation.

I’m also interested in the discussion regarding “coercive debt exchange.” Even if TIA does not prohibit exit consent, the question regarding abusive utilization of exit consent would remain. In Katz, the court found no contractual breach by denying the issuer’s implied duty of good faith and fair dealing (and later cases followed it). However, there could be other aspects to be considered in examining the enforceability of majority’s consent: vote of conflicted bondholders and suppression of free choice of bondholders.

In Hackettstown National Bank v. D.G. Yeungling Brewing Co., 74 F. 110, the court focused on conflict issue, stating that “a vote at a meeting of bondholders, sanctioning a modification of the rights of the bondholders, passed by a corrupt majority for the purpose of effectuating such a collusive consent, is not within the power contemplated by the provision in the trust deed.” In addition, the court cited Jackson v. Ludeling, 21 Wall. 617, stating “when two or more persons have a common interest in a security, equity will not allow one to appropriate it exclusively to himself, or to impair its worth to others.” The case implies that conflicted bondholders’ votes (the majority acted in the interests of the principal stockholder) are unenforceable to minorities, or majority bondholders owe some implied duty to minorities (e.g., duty to make a bona fide vote). Exit consent seems to create a kind of conflict of interest, in that consenting bondholders act as if they are holders of new securities (they can increase and stabilize the expected return for holders of new securities by weakening the enforceability of the old bonds). Maybe it is not an appropriate approach to make a piecemeal analysis by focusing only on the portion of the mechanism to amend the terms of old bond, but it is necessary to see the reasonableness and fairness of the entire deal structure. Exit consent is distinctive at least from Hackettstown because the majority’s interest is not totally personal or unique to them (all bondholders have equal opportunity to receive the new bonds.

Suppression of free choice is typical in coercive two-tier buyouts, where takeover bidders thread stockholders that dissenters at the first step would receive inferior value at the second step. In order to support the reasonableness and fairness of the deal, it is common to guarantee that dissenters at the first step can also receive the same value at the second step and to make appraisal right available to dissenters. The similar effect is attainable in exit consent by making the old bonds (as amended by exit consent) convertible to the new bond during the reasonable period following the exit consent. While obtaining majority consents under this condition would give more supports to the reasonableness of the deal, I’m wondering whether such arrangement undermines the effectiveness of exit consent (or simply it is not necessary to consider under Katz’ paradime).

PCV, I agree that Marblegate may not be all that helpful to figure out the limits for Venezuela and PDVSA to use exit consents. Under the interpretation method proposed by Ryokichi, the TIA would be relevant because the parties would be agreeing to "restrict what is restricted under the TIA." If so, the court would have to look for guidance from TIA case law that existed at the time of issuance of these bonds, unless the court finds the mirroring language was included with the intention of tying the interpretation of PDVSA and Venezuelan bonds to the evolving interpretation of the TIA. The latter seems like a farfetched logical jump under contract law, especially given that Marblegate was a "surprise" decision against the trend of limiting the use of exit consensus. In the case of the Venezuelan bonds, this is even more troublesome because they are issued under Fiscal Agency Agreements (an alternative to trust indentures), and it would be somewhat illogical to tie their interpretation to a statute build to govern bonds issued under trust indentures.

Ryo and Maria, you both make excellent points. You've gotten me wondering whether we might learn something about when and where Exit Consents should be used by looking at the recent restructurings where they were not used (but, in theory, could and should have been).

Argentina stands out. To my mind, somewhat bizarrely, Argentina did not attempt to use Exit Consents in its 2005 bond restructuring. Had it done so (by, for example, removing the pari passu clause in its old bonds), it might have saved itself more than a decade of litigation and billions of dollars in eventual settlements with holdout creditors.

I'm guessing that there was some reason here; after all, the lawyers surely knew about how to use ECs by 2005. Maybe Argentina, at that time, wanted to be more investor friendly? (in hindsight, given the rest of the litigation saga against the holdouts, that seems to have been pure idiocy). There is a story here, for sure. And if I were an Argentine taxpayer, I'd want to know it.

And, let us not forget, Greece didn't use this technique in 2012 with its foreign law (English law) bonds either. It also could have. I don't remember the timing for Greece vis-a-vis the Assenagon case though -- maybe the English courts had already indicated their hostility to the technique by then. Argentina though . . .

Something black in the lentils.

I think even if we concede that Marbelgate functions as a precedent that applies to Venezuela's and PDVSA's bonds, Venezuela and PDVSA should be wary of executing an equally aggressive restructuring via exit consent as was executed by the overwhelming majority of Education Management Finance Corp.'s secured debt holders. Because PDVSA is an instrumentality of Venezula, it is vulnerable to having it's corporate veil pierced (thereby making Venezuela responsible for its debts) should the courts interpret a restructuring as an abuse of the corporate form by the sovereign.
For example, when Turkmenistan transferred assets from its state-owned oil company to another SOE in order to escape liability from an adverse judgment, leaving the oil company devoid of assets and with funds vastly insufficient to satisfy the creditor’s judgments, the courts allowed the creditors to pierce the SOE veil and hold Turkmenistan’s government liable for the company’s debts. To engage in the Marblegate kind of exit-consent restructuring is very much analogous to the example of Turkmenistan and the few other nations that have been held liable for the actions of their SOEs. So while contract law (as it would be applied in the relevant courts as Maria and Ryo examine above) may give PDVSA the ability to execute that kind of restructuring, the courts would very likely find under applicable corporate law/equitable principles that such behavior is an abuse of the protections afforded by the corporate form justifying holding Venezuela liable for PDVSA’s debts.

In my view, the EDMC's deal was well-structured out-of-court restructuring deal, in that the transfer of the assets were structured as foreclose sale. I think such structuring contributed to EDMC's mitigating the risks that the transfer of assets or majority creditors' vote would be found as abusive or fraudulent.

That is, the transfer of assets is the result of the secured creditors' exercising of their rights, and 98% creditors' consent supports the reasonableness and fairness of the consideration paid by new EDM. In addition, while the different treatment to consenters and dissenters (i.e., senior/junior distinction for secured creditors, and no delivery of new securities to unsecured dissenters) is coercive, there was no separate acts of majority creditors that were purported to deteriorate the minorities’ rights. It remains difficult to find a legitimate reason to discriminate dissenters in distributing the consideration of foreclosure, but the aggravation of the old notes was only a reflective effect of the secured creditors' exercising of their rights (when substantially all of the assets were collateralized, it may be justifiable to say that new EDM cannot deliver the new security unless the unsecured noteholders agreed to receive it).

While the situation is different in PDVSA (it collateralized only a few assets) and foreclosure sale is not totally available, I believe that such kind of restructuring deal is viable option for PDVSA. It is not an unusual method in out-of-court restructuring practice to transfer entire (or good part of) business and distribute the consideration to creditors, based upon the majority consent of creditors. As long as the consideration is fair and not fraudulent (on this point, majority consent of creditors, which include sophisticated financial institutions, would give some protection) and treatment of creditors is not discriminative, such deal can be seen as a legitimate restructuring deal in arms’ length terms. I’m skeptical as to whether such an arms’ length transaction would also constitute a ground for veil piercing. If that is the case, the unsecured noteholder of Marblegate case should have had a good chance to pierce the veil to EDM parent (and reverse pierce to new EDM)? Isn’t such case distinctive at least from Turkmenistan’s case, in that majority creditors’ consent demonstrate the reasonableness of the deal terms?

Ryo, I agree that if you can get 98% of creditors to agree to a restructuring like EDMC did, the chances of a veil-piercing are very, very low. But I worry that because PDVSA is Venezuela's "cash cow," there is a much stronger chance that you will have a much greater number of holdouts. Plus, coercive action by SOEs, because their primary shareholder is a sovereign, is going to have a much different connotation. I think PDVSA can absolutely use aggressive incentives to get its bondholders to sign on to bond exchange that allows PDVSA to reform its debt profile, but I believe that if they are to go as far as asset-stripping, that may expose PDVSA and Venezuela to increased litigation risk from holdouts.

Sydney and Miata, thank you for your clarification. I agree that too much coerciveness would risk the deal. I think I share your concerns about the possibility of abusive utilization of exit consent. Interesting point is the difficulty to draw a line between permissible inducements (like those upheld in Katz) and excessive coerciveness (aggressive incentive amounting to asset-stripping). Do you have any idea on that (how it can go so far as unjustifiable asset-stripping)? The percentage of non-conflicted third parties' affirmative votes would be one of the factors to be considered, and the terms of the exit consent itself (whether the terms are so aggressive that the bondholders' free choice can be oppressed) would be another. What I tried to do in my second comment is to reduce the coerciveness of exit consent, by changing the situation from where the prisoner's dilemma works to where dominant strategy equilibrium appears.

But Venezuela does not need exit consents to make holding out as a creditor of PDVSA an unattractive option. First and foremost, the oil is owned by Venezuela. As a shareholder, Venezuela is under no obligation to continue contributing its assets to the corporation, particularly a distressed corporation. The very point of incorporation is to allow a shareholder to cap its losses at the value of capital invested. Withholding additional investment is not evidence of abuse of the corporate form, but evidence of the anticipated use of the corporate form.

Further, the PDVSA entity that issued the bonds is a holding company for an array of subsidiaries only one of which guaranteed the bonds. That the remaining subsidiaries did not guarantee the bonds is a strong indication that bondholders did not have, and should not have a claim on the assets of those companies. Unless the subsidiaries are under some obligation to distribute profits up to the parent, Venezuela can operate PDVSA the holding company as a useless shell entity without actually stripping it of assets. Under a Marblegate-type analysis, this would preserve the formal legal assets of PDVSA while preventing creditors from having access to the fruits of those assets. Venezuela can access the earnings at the subsidiary level through its role as sovereign rather than shareholder using taxes, mandated subsidies, etc...

Given what Venezuela can do without exit consents, it would seem fair to view the use of exit consents as a mechanism for making the process more legitimate and less coercive by giving the creditors a voice in negotiations.

Marblegate at least signals to debtors that the Second Circuit is willing to accept very debtor-friendly reconstructions if the restructuring can sufficiently comply with the legal formalities governing the respecting parties. In Marblegate, that meant convincing the court a foreclosure sale/recapitalization can be compliant with the TIA. For Venezuela, it will mean convincing a court that the restructuring, at least formalistically, complies with the contract. Given the line of reasoning that was acceptable in Marblegate, it does seem that added concerns as to injunctions against sovereigns, absence of bankruptcy as an option, etc., would weigh even further in Venezuela’s favor.

For PDVSA – perhaps the court would prefer to interpret the “instrumentality” exception of the TIA in such a way that allows them to make the reasoning in Marblegate useful. In other words, a narrow interpretation of “instrumentality” finding PDVSA to not in fact be exempt, might permit the court to apply the same reasoning it did in Marblegate – assuming PDVSA is not exempt from the TIA on other grounds. Should PDVSA elect to pursue exit consents, it will want to choose amendments that do not appear overly coercive. Overly coercive amendments would make veil-piercing more likely if/when the restructuring gets challenged.

I think the dissent in Marblegate, along with the other recent cases (see e.g. Assenagon Asset Management), offer signs that Marblegate may hold very little weight in determining the legality of a potential PDVSA exchange offer. While I agree with Russell's point that Venezuela is under no obligation to continue putting assets in PDVSA, such behavior by the sovereign still plays into the hands of creditors, who could use it as additional evidence of abuse of the corporate form. Given what we know about Venezuela's relationship with PDVSA, and despite the sovereign's advantage in not having bankruptcy as fallback mechanism, Marblegate's reasoning is strikingly tenuous. The appellate court's reversal of the district court's decision is largely based on policy considerations that courts will probably interpret very narrowly. After the district court decision, Mark Roe wrote that "[i]f ruling on policy grounds alone is ever justifiable, doing so under section 316(b) is particularly inappropriate because the court cannot obtain a stable, appropriate policy result." With this reasoning in mind, and given Marblegate's unexpected decision, it is not unlikely that the court could find that giving PDVSA bondholders the "choice" between (1) accepting new bonds with less favorable payment terms and (2) retaining old bonds that have been stripped of many of their protections, is simply a coercive exit-consent transaction.

We actually disagree with Khaled. The hoopla around Pari Passu (even though it has arguably been reined in by later decisions) continues, and so too does it for Marblegate. We now have two out of left field decisions (NML v. Argentina and Marblegate) with courts demonstrating that they are very debtor friendly so it would not be unreasonable for a court to adhere to Marblegate's broad holding of what the TIA stands for, even though there was the Court of Appeals decision after Marblegate.

We have more of an issue with whether Marblegate is even applicable here because of the lack of bankruptcy as an option for Venezuela and arguably PDSVA as explained above in the initial post. The whole point of TIA Sec. 316(b) which is the applicable statute in Marblegate "was intended to force bond restructuring into bankruptcy where unanimous consent could not be obtained." So even if the exit consents ultimately used by Venezuela/PDVSA are found to be too coercive where do they go from there?

In relation to the gold clause cases (particularly U.S. v. Perry), there they found abrogating the bond terms to be invalid but the result of the case was effectively in favor of that change because there was no standing as there was no damage. But then that brings up the question, what is enough damage? As they arguably took a 69% decrease in payments. Wasn't this a "core financial term" that had been changed? Does this play a role in defining what is deemed to be not "excessively cohesive"?

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