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Inter-Creditor Duties in Sovereign Debt

posted by Mark Weidemaier

This is a joint post by Mitu Gulati and Mark Weidemaier

As we discussed in a couple of earlier posts, we have been thinking recently about the use of exit consents to restructure sovereign debt, especially in the context of Venezuela and PDVSA, the state oil company. Though focused on corporate workouts, Bill Bratton and Adam Levitin's new paper, The New Bond Workouts, raises questions that also matter in the sovereign context. Bratton and Levitin give a detailed account of the Second Circuit's Marblegate opinion, a 2-1 decision that seems to authorize very aggressive use of the exit consent technique. (Creditors were essentially given a choice between accepting the restructuring plan or being left with claims against an entity that was nothing more than an empty shell.) Bratton and Levitin generally approve of the Second Circuit's decision, but also suggest that courts should revive the doctrine of intercreditor good faith to police against coercive workouts of bond debt.

Bratton and Levitin also talk about how, after Marblegate, bond issuers might be tempted to use both the exit consent technique and collective action clauses. Doing so might put enormous pressure on creditors to participate in a restructuring. For instance, an issuer might design an exchange offer in which participating creditors also vote to eviscerate the payment terms of the old bonds--essentially, threatening potential holdouts that they will be left with worthless instruments. In the English Assenagon case, the court rejected a similar use of exit consents and--interestingly enough--justified this decision in part by invoking something like a duty of good faith among creditors.

To highlight the link to sovereign restructurings, it is possible that exit consents would play a role in any restructuring by both Venezuela and PDVSA. Some rumors are also circulating that Venezuela might attempt to pair exit consents with collective action clauses, along the lines described above. The important question, then, is whether U.S. courts will find ways to limit unduly coercive methods. As we explained in another post (also linked above), Marblegate involved the Trust Indenture Act, which does not apply to foreign sovereigns (and Venezuela does not use the trust structure in any event). Still, the case may prove instructive. And as Bratton and Levitin also point out, there are old (but never overruled) New York cases that support a rule that creditors owe at least minimal duties to each other in the context of a workout. 

A careful examination of the facts in Marblegate should caution against assuming that bond issuers and creditor majorities can implement coercive restructuring plans. Indeed, in Marblegate, there was an obvious holdout problem, with one creditor trying to get a disproportionate share of the limited pie. The equities will not always be so clear. In the sovereign context, it is not clear where the limits on coercive restructurings will come from, if not from the Trust Indenture Act. But since both Venezuela's and PDVSA's bonds are governed by New York law, one would assume holdout creditors will begin by looking there. If so, perhaps those old New York cases will be dusted off and given new life in the modern context. 


Mitu and Mark pose a very interesting question regarding the implications for the sovereign debt context of the recent fracas over Trust Indenture Act section 316(b) in the Southern District and the Second Circuit.

Our paper accounts for the Southern District’s Marblegate ruling as a judicial action taken in response to a perceived need to police coercion. Contract law’s policing toolbox being for all intents and purposes empty, the court turned to a fact-bound 316(b) case called Mechala and a single line of the TIA’s legislative history and crafted a broad prohibition against unconsented impairment of the right to be paid in connection with a restructuring. The new reading held out needed process protection on some fact patterns, but was overly broad and also covered situations that raise no red flags. Significantly the Second Circuit, in reversing Marblegate, almost entirely avoided discussion of the reading’s policy implications and relied solely on the section’s legislative history. So far as concerned the legislative history, the Second Circuit had much the better of the argument.

The Marblegate reversal returns us to square one and the deficient contract law tool box. Marblegate brought coercion in bond restructurings back to the doctrinal front burner, and conceivably could prompt a search for alternative policing tools. We hope so, and make some suggestions even as we highlight numerous frictions. But we are not optimistic.

If Venezuela uses the amendment procedure of its bonds to convince enough creditors to use the CAC, would New York law still matter? In theory, as long as Venezuela gets enough creditors to change the applicable law and to take back its jurisdictional waiver, NY Courts would have to find an independent basis for jurisdiction. This would be hard, since in theory the CAC could be used in a way to strip the bonds of any effect in New York. Another route for jurisdiction would be for the court to take the Assenagon route and disregard the exchanging creditor's votes. This option seems a little farfetched if Venezuela is smart and uses the vote only to transform the bonds into local law bonds. In that case, Venezuela would then have access to more tools to change the terms of the hold-out bonds and the act of state doctrine would probably protect it from litigation.
If Venezuela can't reach the CAC threshold, then I also wonder if a court would be willing to disregard amendments made through exit consent, because the options available for the exit consent are significantly less drastic than those condemned in Assenagon or in old New York cases (at least for the bonds with CAC).

I actually love this idea, but amending governing law (to local law) would leave the issues raised in the Gold Clause cases (NY court may find subsequent change of law as breach). Then amending jurisdiction (to local court only) and/or taking back the waiver of sovereign immunity (while it is “irrevocable” waiver) would also be necessary, but wouldn’t the courts empathizing with Assenagon find it coercive enough to be invalidated if the majority changes the holdouts’ bond term into something saying “the issuer can do whatever it wants”? Innovative formality could create higher hurdle for courts trying to reverse the effect of majority voting (so it’s worth trying), but I’m a bit hesitant to heavily rely on it, being afraid that the equity would focus more on the substance.

It would be more important to avoid making the courts feel obligated, or giving them a good excuse, to introduce broad black-box mechanism such as good faith doctrine which enables the courts to draw any (even ad-hock) conclusions that they believe are righteous. From the debtor’s perspective, I hope that affirmative votes by the requisite majority having no personal interests (suggesting the economic reasonableness of the exchange) would be sufficient to meet the possible policing standard.

While the Second Circuit in Marblegate did not expressly cite to the doctrine of inter-creditor good faith in reaching its conclusion that 316(b) had not been violated, the analysis was highly fact-specific. The court seemingly focused on the aggregate benefit for all creditors rather than the harm to the holdouts. We are not convinced the analysis in Marblegate would significantly differ had the inter-creditor duty of good faith been applied.

In the context of Venezuela, the facts and circumstances will be imperative. As in Marblegate, where the court seemed to value the aggregate benefit of the majority at the expense of the minority, an evaluation of a Venezuela restructuring might be similar. Furthermore, given the dire financial straits Venezuela and it people find themselves in, this adds additional incentive to approve a restructuring that can work for most if not all. Absent evidence of clear expropriation (through use of exit consents or other bondholder approved measure), the law concerning good faith between creditors is unclear.

I support Bratton and Levitin's proposal to revive the doctrine of intercreditor good faith. We ideally want a world where people are respecting each other, including creditors, but this goes against precedent: creditors have no duties to each beyond what is in the contract. If the contracts allow for aggressive measures like exit consents paired with CACs, then that should be allowed. Creditors are governed by the terms of the contracts, and especially in Venezuela/PDVSA as we are dealing with sophisticated parties. Ever nuisance of their relationship is governed by the contract and up until now there has been no good faith duty between creditors. The parties are just getting what they bargained for, which does not include good faith. Why should they get it now ex-post because they do not like the outcome of their bargain? That doesn't seem fair. You get what you bargained for.

On the other hand, something feels off to me that the legal system would allow such coercion. Yes, if we follow form over substance, then there is no good-faith duty, but at the end of the day I feel like the legal system is trying to do what is fair and just and pairing CACs and exit consents is going to leave creditors with absolutely no option but to succumb to restructuring. This doesn't feel right.

I also have to echo Ben, Ed, Tres and Lauren. I think it is all going to come down to facts. As they explained, in Marblegate the court looked to the aggregate benefit, but again in the Pari Passu line of cases, the court did not. It is worth making the good faith argument and if we have a particular nasty set of facts (exit consent with CACs amending the legal jurisdiction?) we may have a shot but like Bill Bratton I am not optimistic.

I first agree with Alix’s "you get what you bargain for" premise. The usage of CACs and exit consent are nothing new and they ultimately were contracted for in the bond. While probably coercive, it could be said that Venezuela retained some sort of right to “coercion” by contracting in these tools. Agreeing bondholders are then just following rules set forth in the contract and good/bad faith is not an issue.

Maybe context matters? A hypothetical situation could be conceived (maybe an economically stable country wanted to unnecessarily lower its debt by restructuring) where the aggressive use of exit consents in tandem with CACs seems inexcusably coercive by both the debtor and consenting creditors and some sort of good faith rule should be required. (However, I think this might be more of an indication of fraud) Conversely, looking at Venezuela’s severe economic situation and the very real possibility of default, the aggressive and “coercive” usage of exit consents and CACs seems more like a necessary act.
Conceivably, the use of coercion could lead to a successful restructuring (complete with the prevention of a sovereign default and fair compensation for investors – all while sticking it to potential holdouts) which other “less coercive” measures would not attain.

Also, maybe I’m wrong, but I would have to think the addition of an inter-creditor good faith doctrine would cause many judicial headaches. Already complex litigation would now concern the good/bad faith motives of tons of bondholders. Maybe it is just easier to have a “every bondholder for his/her self” doctrine and leave it at that.

I appreciate the possibility that a revived good faith doctrine could bring in the flexibility needed to deal with very fact specific restructurings but I am unpersuaded that the doctrine is strong enough to carry the burden of complicated restructurings. It is difficult for me to see courts dealing with sophisticated financial transactions in the US to be willing to use a generic common law remedy which has been weakened for decades.

I am in agreement with Alix that since creditors have no duties to each other beyond what is in the contract, changing this status quo would raise many uncomfortable questions and make the idea of a good faith standard less appealing.

Several of us have mentioned the fact-specific inquiry in Marblegate and that a very fact specific inquiry will be required in the case of Venezuela. I’ve been beating the veil piercing drum from the start, so why stop now; the use of exit consents and CACs and whether they are unduly coercive will have an effect on the veil-piercing claim. As a holdout creditor, no matter what the deal Venezuela offers me I am going in for the veil piercing case and any excessive coercion from Venezuela will help strengthen my case.

A question that I have is regarding how to interpret the TIA provisions which were written into the bonds? Do we read them with the legislative history found in Marblegate (and probably how the drafters of the bonds wanted those contractual provisions to be read) or do we look at TIA just through its contractual language? The result could produce vastly different outcomes.

I think the last set of questions you posed were very interesting, Max.

I think that Marblegate and the TIA could be very relevant in interpreting the ex-ante expectations and bargaining that PDVSA and its bondholders engaged in. Obviously PDVSA is not actually subject to the TIA as an instrumentality of a foreign sovereign, but it issued bonds that conform to the TIA's requirements anyway, suggesting that PDVSA either wanted or anticipated that the TIA would apply to its bonds or be instructive in how courts would interpret the bond terms. In that case, Marblegate could be a very powerful tool in countering holdout creditors that might oppose an otherwise unobjectionable "coercive" restructuring or other debt workout by clamoring for PDVSA's corporate veil to be pierced - as we have seen, courts are generally reticent to pierce the veils of domestic corporations, let alone foreign state owned enterprises without some incredibly grave and blatant misbehavior on the part of the sovereign. Marblegate tells us that highly "coercive" restructurings are just part of normal and anticipated corporate behavior - thus, if PDVSA were to aggressively use exit consents to restructure, that shouldn't be considered behavior warranting veil-piercing.

While I recognize that an inter-creditor duty / covenant of good faith could be a useful mechanism for policing coercion of potential hold outs by creditors, I do not understand how this duty can arise out of contract law. Two creditors are not in contract with each other, rather they are each in contract with the sovereign. To illustrate the distinction, the TIA-like provisions in Venezuela's bonds prohibit a majority of the creditors from accepting a change in the payment terms proposed by the debtor on behalf of other creditors. The counter-party is the debtor, not the other creditors. A group of creditors could not, for example, agree amongst themselves to amend the bond to provide a higher interest rate without the consent of the debtor.

There may be a basis for an inter-creditor duty of good faith, but it seems a stretch to consider the bond contract to be that basis.

I agree with Alix in that parties have no duties beyond what is in the contract. Coercive measures are permitted and they should not be disallowed because of some implied duty of good faith. I would argue the parties contracted for a right to be coercive when necessary and creating a duty of good faith frustrates the contract. Additionally, changing the status quo simply creates added uncertainty amongst bondholders. I also am concerned that such a good faith reading, if it was found a sovereign acted contrary to that duty, would bolster a veil piercing claim.

Further, as Maxim notes, the use of exit consents and CACs, depending on how they are structured, could bolster a creditor's veil piercing claim. If the deal is too coercive, then there is added support for a veil piercing claim and if the deal is not coercive enough there is a risk of not enough creditors taking the deal. The trick is to be coercive enough to be persuasive, but not more. The question is how to do this. Is consent from the majority enough to protect the sovereign from a veil piercing claim? Or is more needed?

I’m curious what courts will make of Alix’ point that pairing exit consents with CACs essentially leaves almost no option for bondholders but to cede to sovereign demands. My gut instinct is that a well-crafted restructuring using those tactics in conjunction could not only leave creditors with little option but also radically alter the bargaining power paradigm that has existed until this point. If a sovereign so chooses, it could make the old bond essentially worthless while forcing a switch to a new bond with potentially extravagant haircuts. At this stage it would leave only the courts as a final resort in this situation.
Obviously, there are incentives for the sovereign to avoid doing so, including the fact that protracted litigation is hardly a plus for any party. But what complicates matters for me is the fact that there is no clear understanding of what a court will construe as coercive. From my understanding anything clearly ludicrous, like a 95% haircut, will be frowned upon. But how far does the line extend? And how will a court react when faced with a situation like Venezuela where the financial situation is so dire a heavy haircut is almost certainly required?

Two points:

1) On Russell's point, I think the meaning of the term "inter-creditor" extends beyond the confines of its semantic definition. As I understand it, the court has interpreted it to mean that there is an implied contractual duty of good faith where the bond contract between the issuer and creditors gives rise to the ability of a majority of bondholders to screw over the minority. You are right to say there is no contract between creditors per se, but there is a contract between creditor and debtor that allows creditors to breach the implied duty between them, if one exists at all.

2) I disagree with Alix and Miata. It is quite a stretch to assume that supplanting 316(b) with the duty of good faith doctrine would necessarily lead to a prohibition of any and all aggressive restructuring techniques adopted by the debtor. After all, Bratton and Levitin agree with the outcome of the Second Circuit’s decision, and argue that an implied duty of good faith would not necessarily preclude a similar rationale – it would simply provide a more flexible framework on which courts can base their analysis. In other words, it would be a much more effective tool to police against coercive workouts of bond debt than 316(b). Bratton's and Levitin's argument is premised on the assumption that OF COURSE coercion should not be permitted! And, adopting a more fact-sensitive tool like the duty of good faith allows courts to reach more just outcomes for both debtor and creditor alike in future cases.

Max raises a very important question at the end of his comment, and Sydney gives an insightful response. Indeed, PDVSA is not subject to the TIA. It remains a mystery why the language appears at all--maybe it just follows from corporate common practice. PDVSA not being subject to the TIA means that TIA legislators were not legislating with entities like PDVSA in mind. This means, to me, that the legislative history that the Court relied on in Marblegate will not be relevant in any PDVSA litigation. Instead, the matter will be one of contract language interpretation. I think this is why the paper by Bratton and Levitin is (perhaps unintentionally) so interesting for observes of the Venezuelan crisis: by taking a look at a Bratton-Levitin world where the TIA 316(b) is repealed, we do away with legislative history arguments and are left with other devices of interpreting the 316(b) language that would still exist in bonds, mirroring exactly the case of PDVSA. These devices will have to be contractual, as the authors explain. Good faith could and should play a role, but also should other traditional interpretive tools, like allocation of risk. The tool box is deficient, but this just means there is good room for creative thinking.

What do you think is the substance of “good faith” obligation? From the debtor's perspective, I don't want to have my live-or-die deal subject to black-box tests of coerciveness or good faith. I doubt that coerciveness leave creditors with little option. Institutional investors have their network and easily cooperate with each other to block the deal, if it is unreasonable. I also doubt the courts’ capability of evaluating the economic benefits of the proposed deal, as we can see the complexity of appraisal right cases. The discussion of good faith obligation was raised in the cases where majorities pursued their personal interests (e.g., bondholder foreclosed assets to benefit its related company, shareholders tried to transfer value from bondholder to shareholder). I want that courts refrain from getting into detailed scrutiny, as long as the deal is made in arms’ length and supported by disinterested majority.

Another concern is TIA 316(b) language incorporated into bond terms. The structure of bond terms is different from TIA 316(b). Formal amendments to “core” terms of bond are covered by different provision, and the language similar to TIA 316(b) is provided in addition to them. This suggests that the language is intended to regulate something else, unless there are explicit drafters’ intention that they just wanted to follow TIA practice, whatever it says. The interpretation could be something similar to the district courts’ one, while it seems strange to me (radical application thereof may restrict even commercial deals that may risk the debtors’ ability to repay its debt?).

I don not know where the rumors of the alleged Venezuela/PDVSA strategy to use an approach with both CACs and Exit Consents come from, although it seems perfectly plausible. In any case, what I find very interesting is the whole discussion on the inter-creditor good faith duties and how could such a concept permeate into any sovereign (Venezuela) or quasi sovereign (PDVSA) debt restructuring proceedings.
It is my personal view that, even as creditors to a common issuer are not contracting parties between themselves, they are into contractual relationships that put them in an equal footing standing with third-parties (i.e. other contracting parties - bondholders). So, even as you could argue that there are as many contractual relationships as there are bondholders, it seems to me that such contractual relationships are not by any means independent from one another. The existence of equal footing creditors is an essential consideration of the bond indenture itself.
On the other hand, I do have to agree with many of the previous comments in the sense that allowing any inter-creditor good faith argument to interfere with any debt restructuring process conducted in strict compliance with the forms provided in the bond indentures could have catastrophic consequences, while potentially rendering contractual mechanisms such as CACs or Exit Consents as utterly useless. I think any analysis or good faith consideration would need to be made in a very factual way, taking into consideration specific conducts of both the creditors and the issuer during the restructuring process. The implementation of deals by using simultaneously collective action clauses and Exit Consent, by itself, should not be considered a breach of inter-creditor good faith.

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