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Stripping PDVSA's Assets

posted by Mark Weidemaier

This is a joint post by Mark Weidemaier and Mitu Gulati

In a previous post, we talked about how ordinary corporate-law principles, and especially the rules concerning piercing the corporate veil, might play an important role in any debt restructuring conducted by Venezuela or PDVSA, the state oil company. As an example, we cited the fact that PDVSA doesn't own the oil reserves it exploits and the possibility that Venezuela might transfer the right to exploit these reserves to a new entity. Readers who have been following the Venezuelan crisis will recognize that we were not-too-subtly referring to a proposal floated back in October 2016 by Ricardo Hausmann and Mark Walker, writing on Project Syndicate. (Registration required.) In a nutshell, their proposal with regard to PDVSA is that Venezuela can induce PDVSA creditors to participate in a restructuring--conducted either in bankruptcy or through the use of exit consents--by withdrawing or modifying PDVSA's right to exploit hydrocarbon reserves. Essentially, that is, Venezuela can strip the company of its primary productive asset.

The proposal may seem a touch lawless, and it certainly has its critics, though Hausmann and Walker point out that the sales documents accompanying PDVSA's bonds (like this one, p. 9) disclose the risk. For present purposes, we highlight the proposal only as a fairly obvious illustration of the ways in which liabilities of one of the country's two primary debtors (the government and PDVSA) might wind up being imposed on another entity. In this case, of course, any new entity formed to exploit hydrocarbon reserves would have to consider potential liability under fraudulent transfer or other theories. Moreover, Venezuela should expect PDVSA creditors to try to pierce the corporate veil, thus holding the government liable for PDVSA's debts. The government already exercises substantial control over PDVSA. If it were to withdraw the right to exploit the country's oil reserves, the case for veil piercing would become compelling. And as we noted in our last post, the government would find it difficult (though perhaps not impossible) to restructure these claims.

It is not obvious that PDVSA's bond disclosures would prevent its creditors from going after Venezuela. Legally, the question isn't about the adequacy of PDVSA's disclosures. Instead, the question is something like this: Does the fact that investors knew Venezuela might withdraw PDVSA's exploitation rights mean they (implicitly) agreed not to pursue the government if this in fact happened? It seems plausible--more than plausible, really--that a court would answer "no" to this question. After all, investors dealing with close corporations always have at least some reason to fear asset stripping; yet the law protects them anyway. One reason is that, when a shareholder removes corporate assets from an insolvent company, it inverts the normal priority scheme in which owners come last in line. That seems a fair description for what Hausmann and Walker propose.

On the other hand, the "disclosure" argument has enough merit that it gives Venezuela another weapon against holdouts. Remember that the primary goal of Hausmann and Walker's proposal is to create leverage to induce PDVSA creditors to participate in a restructuring. With enough participation, holdouts might present a manageable problem.


An additional question that I have on this is what kinds of contract terms will govern the PDVSA bonds vis-a-vis the Venezuelan sovereign, if the PDVSA bondholders do succeed in veil piercing. Will they be given the same contract terms that they had against PDVSA (importantly, the requirement of unanimous approval for any changes to payment terms) or will the have the type terms that are more standard in the typical Venezuelan sovereign bond (collective action clauses)? Or maybe their terms will be of an altogether different form (maybe there are default terms that apply by statute in NY)?

In a sense, as I see it, the answer to the foregoing question is relevant to the ex ante decision that the Venezuelan government might make as to whether to engage in asset stripping from PDVSA or not. If the end result of asset stripping is that the PDVSA holders now have claims against the sovereign that are even stronger than other claims against the sovereign, that might deter the sovereign from engaging in such shenanigans in the first place.

I agree that Venezuela's argument does have some weight. They disclosed that PDVSA was just managing Venezuela's oil but did not own the Hydrocarbon rights and so the bondholders knew exactly what they were buying. Not safer sovereign bonds, but the bonds of a corporation just managing assets. Why should they get the same treatment as Venezuela's bondholders by piercing the corporate veil? One reason to pierce the corporate veil is to avoid fraud or injustice but how is unjust for the creditors to just get an outcome that they knew was very likely to happen because it was disclosed in the bond contracts? Especially when these creditors are often "vulture" funds who would be deemed to have superior investment knowledge and be well aware of any investment risks.

Were Venezuela to strip PDVSA of all of its assets (including oil rigs, vessels and supporting machinery), I agree that the case for veil piercing would indeed be stronger. That is what got Turkmenistan in trouble in the Bridas case. However, it does not seem entirely straight forward to me that revoking PDVSA's exploration licenses would necessarily make the veil piercing case more compelling. In theory, Venezuela may have legal reasons to revoke PDVSA's license, especially considering that the company has been unable to maintain its ships and that oil output has declined. This decision seems well within the exercise of Venezuela's regulatory power as a sovereign. In this case, would the revocation itself necessarily strengthen a veil piercing case against Venezuela? To disregard Venezuela's right to revoke the license based on its regulatory power, it feels to me that the court would need to decide either that PDVSA's problems were a pretext for Venezuela's actions or that Venezuela caused PDVSA to breach the terms of the license. Either way, the court would probably be looking for answers by examining the relationship between PDVSA and Venezuela before the revocation of the license.

The impact of the stripping on the veil piercing analysis depends on the purpose and the way of the stripping. If, in an objective observation, Venezuela has any legitimate reason to do so other than to shield the assets and effectuate the stripping in an opportunistic way, veil piercing would be more likely. However, as Maria discusses, Venezuela may have a legitimate reason to do so, such as improving the production performance that is critical to the country's development, taking into consideration PDVSA's suffering intervention of its business due to financial difficulty and its recent poor performance. Even in concession-type PFI deals, such situation may justify and trigger the government's termination rights on the concession agreement. Also, under such situation, it is quite usual to work on negotiated restructuring deal under which the debtor transfers its assets to a new entity. On the other hand, even in such situation, PDVSA should be entitled to receive the present value of its business (i.e., Venezuela cannot strip the assets without paying just compensation). It is a standard practice that, upon a prematurity termination of concession, the concessionaire receives fair value of the concession right (while the pricing could different depending on whether the termination is for cause or not) and, also in a restructuring deal, the debtor receives the consideration for the assets at a fair value and distribute it to the creditors. I believe that invalidation of fraudulent conveyance of assets is also an "internationally established" legal theory (as the Court mentioned to veil piercing as such) and the prior disclosure regarding the influence of Venezuela over PDVSA cannot totally justify fraudulent conveyance of assets.

The ultimate issue will come down to the intent of the Venezuelan government to withdraw the right to exploit hydrocarbon reserves. The analysis is ambiguous until we figure out the reasons behind Venezuela’s diversion. On the one hand, the Venezuelan government is clearly abusing the corporate form. On the other hand, Venezuela gives itself the right to divert these assets in the prospectus. The question is whether or not a court would be willing to equate Venezuela’s right to divert assets as a creditor’s forgoing of its right to bring suit against the Venezuela on a sovereign veil piercing theory. Finally, if Venezuela gives a legitimate justification for removing these assets from PDVSA and giving them to a new company, a court would not pierce the sovereign veil.

These comments are excellent. My sense from reading them is that veil piercing in the sovereign context is going to be quite difficult (and more difficult than in the corporate context?) so long as there is a regulatory reason for the asset stripping?

Is there a sufficient body of law to be confident of the foregoing though? My guess is that there are not that many cases, and that the ones that are there are highly idiosyncratic and politicized. But maybe not.

We can argue that NML Capital v. Argentina justified the sovereign's exercise of regulatory power. In that case, Argentina exercised its trade- and pricing-control power regarding natural resources and compelled the company to sell natural gas at a negative margin to enhance pubic interests (while it is not stripping of assets, but compelling to sale products at negative margin sounds like partial stripping). The court said such "control was exercised pursuant to publicly announced policies declared and implemented in various statutes and executive decrees," and "the founding statute and decree stated that [the company] was required to comply with the policies of the national government." Provided, however, that even in that case, government subsidized the loss incurred by the company.

I believe that stripping should also be effectuated in orderly way, and fair compensation is important. It would be prudent for government's protection to characterize the transaction as something like taking (justified by public interests and just compensation), so that the stripping would be seen as opportunistic.

I'm sorry, "so that the stripping would [not] be seen as opportunistic."

Whether veil piercing in the sovereign context is more difficult than in the corporate context is not clear. In all cases, veil piercing is the exception, not the rule, and is highly fact specific. So no, the law is not firmly established as to sovereign veil piercing.
In Bancec, the Supreme Court appeared to announce a test authorizing sovereign veil piercing in either of two situations: (1) the sovereign exercises such complete control over the instrumentality that the entity is, in fact, an "alter ego" of the government; or (2) veil piercing is necessary to prevent fraud or injustice. In the corporate context, many jurisdictions (including New York), will pierce the veil only if there is both overwhelming control and the threat of fraud or injustice. On the other hand, sovereigns are expected to have near-absolute control over state instrumentalities, above and beyond that expected of majority or even sole shareholders. This makes it very difficult to say what level of sovereign control is enough to run afoul of (1). One distinction used by courts is whether the sovereign engages in day-to-day control - a power not typically exercised even by majority shareholders.

I think you're on the money PCV. If there is a legitimate reason for asset stripping and the creditors were aware of this risk, it seems unlikely that a court will pierce the corporate veil.

There is some case law, but it generally makes it very challenging to pierce the corporate veil. There has to be proof that the country is using the corporation as its alter-ego, which can be shown through a totality of the circumstances analysis, but overall, looking at the facts of the situation it is going to be hard to meet this burden. One important factor for the analysis is the country controlling the day-to-day operations of the company, but other cases have been dismissed because the plaintiff could not provide enough evidence of this to even meet the pleading standards. There seems to be much speculation of this but no court is going to accept journalists' musings as sound evidence. There may be some evidence regarding commingling of funds (another factor considered in the alter-ego analysis) because PDVSA donates to social projects for Venezuela (perhaps in excess?), but again this is disclosed in the bond contracts. Courts also pierce the corporate veil for fraud/injustice but again is it really injustice that the creditors got what they bargained for?

On the other hand, I agree with your second point. There is limited case law and the NML-Argentina Pari Passu decision was completely unexpected. The court found a way to hold Argentina liable based on a clause that had been boiler plate language for years, wrecking the idea that contracts are predictable. Perhaps a similar trend could take place here. What do others think?

I agree that overcoming the presumption of separateness will prove to be a very difficult task in and of itself, given the many parallels between PDVSA’s relationship with Venezuela, and SOEs and sovereigns in other cases (see e.g., Transamerica Leasing v. Venezuela). Assuming the government maintains the status quo with regards to its relationship with PDVSA and avoids the appearance of impropriety, I find it nearly impossible to conceive of a scenario in which creditors are able to point to evidence of fraud and injustice, particularly given the disclosure documents accompanying the bonds that made the extent of Venezuela’s control over PDVSA abundantly clear. This prediction may change, however, if Venezuela takes up Hausmann’s and Walker’s proposal and strips PDVSA of its primary productive asset. If Venezuela attempts to induce PDVSA’s creditors to participate in a restructuring by withdrawing or modifying its right to exploit hydrocarbon reserves, this will undoubtedly raise a red flag with the court. Creditors will likely exploit this by claiming that Venezuela is simply hiding its assets in order to thwart PDVSA’s creditors and avoid veil piercing. The question here is whether Venezuela can overcome the court’s suspicion of fraud and injustice, and there's insufficient case law to provide a clear indication that the court will rule one way or another.

I believe there is a very slim chance of the corporate veil being pierced. That being said, if anything is going to convince a court to pierce the veil, it is going to be egregious acts by the Venezuelan government to totally deplete PDVSA of assets (without an alternative reason). If in an extreme scenario Venezuela goes after all of PDVSA assets, I agree that disclosures might not be enough. Asset-stripping may be the ultimate version of corporate form abuse and provides very strong indicia of fraudulent behavior by the stripping party (VE). But, as long as Venezuela stops short of asset stripping and continues to treat PDVSA as an independent company (exploring restructuring, bankruptcy, etc.), veil piercing will be a difficult proposition.

I seem to be alone in thinking that the veil piercing concern (specifically for alter ego) is strong. To Alix’s point that bondholders knew they were buying bonds of a holding company and not of Venezuela, I would say that while the creditors originally bought corporate bonds, following the unprecedented (for Venezuela) crackdown on PDVSA autonomy, which ushered massive interference in basic business activities (such as choosing joint venture partners or controlling the budget) the corporate bonds became defacto Venezuelan bonds, not because of the bondholders but because of the state itself decided to treat PDVSA as if it was the government itself.

In addition, because a risk was disclosed does not mean it was “likely to happen.” For decades PDVSA was one of the strongest and best run state owned oil companies with world renowned technical expertise. Following nothing short of a political revolution which burdened PDVSA with government obligations, the company began to have financial difficulties with oil over $100 a barrel while extraction cost less than $25. Through government intervention PDVSA has been forced to spend more on social obligations that it does on its operational AND exploration costs!!

While I agree with Maria and Ryokichi that Venezuela could theoretically have strong grounds for legally revoking PDVSA’s exploration rights, in practice this can only strengthen the hand of the creditor. It was political decisions, and not business decisions that restricted PDVSA’s ability to maintain oil output. For over a decade OPEC and other international oil companies have been sounding the alarm that PDVSA is investing only a fraction of what is necessary to expand output. The government has taken control of this company entirely, and has run it so poorly that it now wants to defraud bondholders by deciding that corporate formalities all of a sudden exist again?

While I think piercing the veil through the alter ego approach would be preferable, the revocation of exploration rights would make this case analogous to the Turkmenistan decision by demonstrating fraud and injustice.

PCV, on the issue of the government's use of regulatory power, I think the Bridas case can give us some guidance, because there the court found that Turkmenistan's ban on exports was not the time of harm that would constitute a "fraud or injustice" for the purposes of the veil piercing test, because "[the] Government's exercise of its sovereign powers may have constituted a wrong to [its instrumentalities creditors], but it was not a wrong based on misuse of the corporate organizational form." I think the courts would apply a similar logic to Venezuela: which hat was the government using, its shareholder hat or its sovereign power hat?
This is where I think there is a difference between PDVSA's oil exploration licenses and other assets will be key. Venezuela will have difficulty to argue it was acting as the State and not the shareholder if it takes the assets from PDVSA. The exploration licenses, however, are given out by the government as part of its regulatory power over the oil industry and have a number of obligations attached to them. If PDVSA is not complying with those obligations and the government decides to cancel the license, the courts can arguably see that as Venezuela exercising its sovereign power to police oil exploration in the country. What I am curious to investigate is whether cases regarding the "act of state" doctrine (i.e. that US courts should not evaluate the validity of a foreign State's exercise of sovereign power) can help support this argument.

I think the biggest argument against veil piercing would be showing how any action Venezuela takes towards PDVSA is different from other sovereign-SOE relationships. The extensive control feature of their relationship is an expected feature of any SOE. Additionally, as others have pointed out Venezuela stripping PSVSA of assets would be a clear indication of fraud, but given the disclosures PDVSA provides this act can not come as a complete shock to creditors if they were to take place. I agree with Max that simply because something is disclosed does not mean it must take place, but the possibility that it could take place was a known possibility and should carry some weight against veil piercing.

To Maria's and PCV's point, while there is little case law on the subject, the most recent cases suggest that courts will respect sovereigns' regulatory interventions in state-owned entities, and will decline to pierce the corporate veil in those instances. For example, New York courts have denied creditors to attach the New York based assets of a state owned bank when its sovereign had taken it over during a financial crisis, analogizing the sovereign's behavior to that of the U.S.'s FDIC. If Venezuela can make a showing that it is stripping PDVSA's assets as part of an attempt to stabilize the industry or the Venezuelan economy, and not merely to hide assets from creditors, courts will be very receptive to that argument.

Additionally, per PCV's earlier question about what would happen to PDVSA's bond terms should creditors successfully pierce the veil and hold Venezuela liable for PDVSA's debts - under the veil-piercing theory (and in previous SOE veil-piercing cases) the sovereign merely supplants the SOE as a debtor. The creditors maintain all of the contractual rights they originally had against PDVSA, Venezuela just has to perform them (or be held liable for their breach) instead.

I agree with Ms. Borges that there is a key distinction to be drawn between the right to exploit the hydrocarbon reserves and PDVSA’s other assets. No matter what, a court looking to make a veil piercing argument on this premise will need to wrestle with the fact that Venezuela could use ordinary business judgment in defense. PDVSA has performed rather abysmally, the discussion of who is at fault for that notwithstanding. I think the court would will struggle with the premise that Venezuela is unable to reassign that right due to poor performance. Now, whether they will accept that argument on its face is tougher to say. But from my understanding in previous cases courts are extremely reluctant to pierce if a sufficient alternative explanation may be provided. Perhaps more importantly, each of the PDVSA bond offerings I read specifically state the fact that these reserves are owned by the state. While I disagree with some of the commentators above that disclosure acts as a general defense for anything PDVSA/Venezuela later do, I think that it firmly sets the central question before the court as whether the situation warrants ignoring whatever business reasoning is advanced in light of the fact that PDVSA would lose its most valuable asset.

I think there is also something to be said regarding the ‘legal right to payment’ versus the ‘practical ability to receive payment’. I am unable to classify this move as falling under the former category rather than the latter. While PDVSA losing the right to exploit these reserves would indeed impair the ability for creditors to receive payment, the legal right, and the important financial terms of the bond, would remain intact.

In regards to Ms. Eggerly's question of relationships between state-owned oil companies, I have mostly focused on OPEC members and in short while there is always heavy supervision the companies are allowed to make independent business decisions and in general enjoy greater autonomy. The most comparable case would be Aramco, the Saudi State oil company, which is just as important to Saudi Arabia as PDVSA is to Venezuela. Among state-owned is companies Aramco is seen as one of the best and is give wide discretion in implementing policies set by the state.

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