A Mini Q&A on Venezuela’s Possible Defense to Foreclosure on the PDVSA 2020

Mark Weidemaier & Mitu Gulati

Along with Ugo Panizza of the Graduate Institute in Geneva, we’ve put up a couple of posts in recent days asking whether Venezuela might have a legal basis for challenging its obligations on the PDVSA 2020 bond (here and here). A large payment of close to a billion dollars is due in a few weeks and there is no money to pay it.  Most important, the bond is collateralized by a pledge of a majority stake in CITGO Holding.

The possible basis for the legal defense is that the bonds, and especially the pledge of collateral, were not properly authorized under Article 150 of the Venezuelan constitution. (This matter has also received press attention over the past few days—e.g., here and here).

As background, provisions in the Venezuelan constitution (Art. 312) and related Venezuelan laws require the passage of a “special law” (our translation) to authorize public indebtedness, but exempt PDVSA from the requirement. However, a separate constitutional provision, Article 150, requires “approval” from the National Assembly for contracts of national interest. We don’t know of situations in which the provision has been invoked. With apologies for possible mistranslations here and elsewhere in this post, here is the text:

Article 150. The entering into of national public interest contracts will require the approval of the National Assembly in the cases determined by law. 

No municipal, state, or national public interest contract can be entered into with States or foreign official entities or with companies not domiciled in Venezuela, not being assigned to them without the approval of the National Assembly.

The law may require in public interest contracts certain conditions of nationality, domicile or any other kind, or require special guarantees

For a Caracas Chronicles piece on this, see here.

We have gotten numerous questions in response to our two pieces, one at Project Syndicate and one here. There were many excellent questions. And since we find this topic fascinating (we are working on an empirical paper on governing law provisions in sovereign debt contracts), we decided to go down the rabbit hole of trying to answer them. 

The caveat here is that while we know a good bit about sovereign bond contracts, we have no expertise in Venezuelan constitutional law. Here goes:

Q1:  PDVSA has never obtained National Assembly approval for any of its prior debt issuances.  Why would approval be required now? And isn’t PDVSA exempt from the requirement of obtaining approval?  

A: Let’s take these in reverse order.

As noted, Art. 312 of the constitution requires a special law authorizing public credit transactions, “with the exceptions established under the pertinent organic law.” The law governing the financial administration of the public sector repeats the requirement of a “special law” but exempts PDVSA “from this Title.” By its express terms, the exemption applies only to that title in that law. It does not purport to exempt PDVSA from requirements found elsewhere in Venezuelan law.

As for the fact that PDVSA has not customarily obtained the National Assembly’s approval for its borrowing, the PDVSA 2020 differs in both form and substance.

Unlike other bonds, the PDVSA 2020 was collateralized by the country’s crown economic jewel. When the bond was issued, it was widely expected that both the government and PDVSA would soon default. Venezuelans were living through a “profound humanitarian crisis,” which would require foreign currency to solve. PDVSA, in part through its control over CITGO, generates essentially all of the government’s foreign currency. Yet rather than taking steps to ameliorate the humanitarian crisis, the government was borrowing even more, and ceding future control over CITGO in the process. The transaction had no apparent economic purpose and, to all appearances, was designed simply to buy Mr. Maduro a bit more time in power. Put bluntly, the decision whether to issue (and, especially, to collateralize) the PDVSA 2020 bond involved the following choice: (i) default now, and begin devoting resources to the humanitarian crisis or (ii) grab a few extra years in office but hand over the keys to CITGO.

Was this choice a matter of “national public interest?” Seems so to us. That’s not so much legal analysis as intuition, or common sense, or something. But it jibes with the reason why these sorts of legislative-approval requirements exist in the first place, which is to reduce the agency costs associated with unfettered executive power.  

Also, look: We’re sympathetic, in the abstract, to the argument that investors can’t be expected to understand every aspect of the borrower’s local law. As we mentioned in our Project Syndicate piece, however, we aren’t dealing with unsophisticated players here. Plus, the National Assembly was jumping up and down at the time saying that approval was required for the PDVSA 2020 bond, and the financial press was highlighting their objections. So, sophisticated creditors would have known the issues.

Q2: Even if a court were to invalidate the pledge of collateral, or even the bond itself, there is still a debt. After default, won’t creditors have basically the same remedies and, if so, who cares about this issue?

A: This is a good and important question. In practical terms, and setting aside the legal issues for now, the question is whether bondholders have enough to fear from a ruling invalidating the collateral pledge (or the bond itself) that they might find it advantageous to compromise with the Guaido folks.

If one looks at the latest bond prices, the PDVSA 2020 is trading at a significant premium (about 3x) over other PDVSA and Venezuela sovereign bonds. If the pledge of collateral is invalidated, the PDVSA 2020 bond becomes just like the others. It seems to us that holders of the PDVSA 2020 might be willing to compromise to prevent this risk, assuming the Guaido folks can offer them something in exchange.

On the legal aspects: Without the pledge of CITGO-Holding shares, a PDVSA bondholder could not attach them (at least, not without proving that PDV-Holding—PDVSA’s US subsidiary, and CITGO-Holding’s immediate parent—was PDVSA’s alter ego). Instead, a bondholder could attach only PDVSA’s equity stake in PDV-Holding. Put differently, PDVSA bondholders would occupy, at best, the position now occupied by Crystallex. It remains to be seen whether Crystallex will be able to force an execution sale of the PDV-Holding shares, in part because US sanctions currently seem to block such a sale. Moreover, to achieve even this position, PDVSA bond creditors would have to overcome PDVSA’s immunity from execution (which retains some force despite the waiver of immunity in its bonds). They would probably have been able to do this, but success was not guaranteed and would take a very long time. Thus, but for the pledge of collateral, these PDVSA bondholders would have less potent enforcement rights, and this is no doubt part of the reason why the PDVSA 2020s have traded at a significant premium.

Q3: What about the President issuing an Executive Order protecting Citgo stock from seizure?

A: We have no particular insight to offer here. As far as we know, the US government is not eager to take such a step. Indeed, after John Bolton’s departure, we wonder whether anyone is even focused on this question. We suspect that serious discussion about an Executive Order to protect Venezuelan assets will happen, if at all, only after Mr. Maduro leaves power.

Q4:  Is there any precedent for a case like this?

A: Yes and no. There are lots of recent examples of governments making similar arguments, although there have been few recent rulings. Some of the classic cases, like Buchanan v. City of Litchfield, involve US municipal debt, are quite old, do not apply New York law, and generally don’t dictate the result or even the analysis here. Still, those cases may offer some insight. In particular, they suggest that, if a government expressly represents that the bond was properly authorized, then bondholders are entitled to rely on that representation. However, the reason for this rule is that bondholders cannot reasonably be expected to detect many violations of local law. For example, if bonds are issued in violation of a constitutional debt limit (as in Litchfield), investors may not have access to reliable data about the government’s outstanding debt. In such a case, if the government affirmatively represents that the loan is authorized, it might be bound by the representation.

Even if this reasoning were applied directly to the sovereign context, it does not tell us what should happen when investors have reason to know about the legal defect. To our knowledge, the most directly relevant recent case involves litigation by Ukraine challenging the $3 billion bond issuance held by Russia. For coverage of this dispute, see here and here. As relevant here, Ukraine challenged the bond on the ground that the government officials involved in the issuance lacked authority, since the bond exceeded borrowing limits specified in Ukrainian law. English law governed the dispute, but we don’t know of any differences in the English law of agency that would be relevant here. That said, how courts decide these cases is often a function of what arguments the lawyers make. 

Although the Court of Appeal rejected Ukraine’s lack of authority defense, it signaled that the important question was whether the bond trustee, at the time of the issuance, knew or had reason to know of the violation of local law. Indeed, this point was seen as so obvious that the parties effectively conceded it. Ukraine lost because (i) the violation of local law was technical and would therefore have been difficult to detect and (ii) because Ukraine itself had represented at various points that the loan was within borrowing limits. (See paragraphs 114-125 in the opinion linked above).

If a court were to adopt this analysis, it seems to us that it would have to decide (i) whether the loan, the pledge of collateral, or both required National Assembly approval and (ii) whether a reasonable investor would have been on notice of this fact at the time of the loan. Representations made by government or PDVSA officials about the loan’s legality would be relevant but not, we think, dispositive. And surely it would also be relevant that members of the National Assembly were publicly asserting that the PDVSA 2020 bond would be invalid if not submitted for approval by the National Assembly and that major financial news outlets were reporting on this controversy. What should a sophisticated financial intermediary have done in such a circumstance? It strikes us as at least plausible that a court might find a lack of due diligence here.

Finally, we’ll note again, as in our last post, that a court would first have to decide whether to apply New York or Venezuelan law. That, ordinarily, will depend on the explicit terms of the governing law provision in the contract. However, interestingly, it was not a major issue that the court in the Ukraine-Russia case wrestled with (maybe the lawyers didn’t argue over it?). But it seems likely to be a major point of conflict if a dispute over the PDVSA 2020 bonds winds up in a New York court. Our intuition is that Venezuelan law will determine whether the PDVSA 2020s in fact required legislative approval but that New York law will govern many other issues. That is essentially the approach the Court of Appeal took in the dispute between Ukraine and Russia (because its analysis assumed the loan in fact violated Ukrainian law). But we are simplifying what could be a very involved battle here.

Comments

[Shi Chen]

I am interested in the tension between the legality of bond contract and reasonable expectation of bondholder.
Although I am persuaded that sophisticated institutional bondholder may be aware of the legal risk of unauthorized bond, but does public report about authorization issued by local government law ever raise a legal presumption that investor should be aware the bond is void as a matter of law and therefore they should not expect the any return at all?
Regardless of governing law provision, there is till many legal questions remained to be answered.
1. what is the legal implication of unauthorized public debt? Is lack of authorization sufficient to void a public debt contract? Or the contract is voidable, at whose option? Or is this a affirmative defense or excuse of the enforceability?
2. Does bondholder, especially retail bondholder, have sufficient notice to the extent that retail bondholder is fully aware of the possibility that this bond is susceptible to void as a matter of law because of the lack of authorization? There is at least several factors to be considered:
(1) does president make any public announcement conflicting with National Assembly? If so, who is more reliable or powerful in that country?
(2) Is extremely high premium presenting some unusual circumstances? Is this void because of illegal high interest? Is this kind of high premium customary in local government?
(3) How accessible is national assembly's public announcement? Is that issued in local newspaper in local language or issued through New York Exchange? What is the percentages of different groups of bondholder, such as domestic v. foreign, institutional v. retail?
I guess the questions may become whether lack of authorization can be enough to void contract or being some less risky? If so, is there sufficient warnings given the totality of the circumstances?

[Eric Fisher]

Conceding that this bond issuance is distinct in some ways from previous bonds where PDVSA had not obtained approval from the National Assembly, what should we make of the fact that the differences between a typical issuance backed by meaningful economic considerations and one backed by this particular collateral are shades of gray? It seems that by allowing the CITGO stake to act essentially as a dealbreaker where previous economic promises did not would lead to a number of meaningful consequences given that a court would have to make the case that this has crossed a specific line implicating "national interest." For instance, would this make it much harder for future debtor states acting in good faith to offer strong assets as collateral when an opposition party (perhaps a despotic one) could somehow block it on a technicality? On the other hand, would stepping in here to render the bonds void or unattachable simply because the stakes are so high incentivize future bond issuers to overpromise in bond swaps knowing that they could buy time and still not ultimately be held accountable if there was a technical rule that would void it? While the facts of this case are ones in which investors should have known the possible impact, having to decide both whether a less clear-cut case is both in the "national interest" and simultaneously legal may shift the equities to investors and ultimately hamstring strapped nations from employing the very few strategies available to them.

[RP]

It seems to me that what you are asking is for a U.S. court to determine whether a bond issue in particular constitutes a 'contract of public interest' or not, under the applicable local law. A legal category--one might add--that not even public law scholars in that particular country can agree upon.

A little context may be warranted by this complex matter: The question of whether long term agreements in general, entailing the country's NOC are contracts of public interest has been often discussed, and has for decades fueled contractual validity and legality challenges from then-sitting political opposition parties in the Venezuelan congress (i.e. what we have been calling the National Assembly for almost 20 years). So a news piece running the story of a lawmaker denouncing a long term agreement on such grounds is far from an unprecedented nor unheard-from issue.

I believe this to be a gordian knot, which will require a very creative and pragmatic approach to reach a workable solution, yet doing so without ignoring the inherent complexities of the matters at hand.

[Brage Humphries]

While I agree that Venezuela has a possible legal basis for challenging its obligations under the PDVSA 2020 bond, there are some background issues that seem to have been overlooked that could play a role in determining whether CITGO would even be seized. A U.S. court may hesitate to enforce the bond because of the ongoing economic/humanitarian crisis in Venezuela and the ongoing power struggle between Maduro and Guaidó. Oil revenues account for around 99 percent of Venezuela's export earnings (https://www.opec.org/opec_web/en/about_us/171.htm). A blow to PDVSA through CITGO's seizure would crush the already struggling Venezuelan economy and only exacerbate the humanitarian crisis in the country. While the 2007 Bundesverfassungsgericht decision suggests that a country may not invoke necessity to suspend the payment of its obligations to private creditors under international law, Venezuela's dire economic situation would likely influence whether a court would be willing to enforce the seizure of CITGO in this instance (and would seem to depend on which creditors own the PDVSA 2020 bond). Because Venezuela is so dependent on oil exports, the attachment of CITGO would have profound consequences for a future rebuilding of the Venezuelan economy.

Additionally, a U.S. court may hesitate to enforce the seizure of CITGO because of the consequences it could have on a power struggle between foreign leaders. While I am not sure of any precedent on this issue, it seems that Maduro's interests are largely short term - to keep everything going and buy him more time in power - while Guaidó's interests seem to be longer term and more focused on an economic rebuilding. CITGO, being an essential component of Venezuela's oil dependent economy, would be a crucial building block in an economic rebuilding. A seizure of CITGO could influence the outcome of the power struggle between Maduro and Guaidó and may be an area that a U.S. court does not want to meddle in.

While Venezuela's 2020 PDVSA bond may be invalid for not receiving approval by Venezuela's National Assembly, even if the bond is deemed valid, there are other factors that a U.S. court may consider in determining whether to seize CITGO's property that should be addressed. Venezuela's ongoing economic and humanitarian crisis and a hesitation to influence the outcome of the power struggle between Maduro and Guaidó could lead U.S. courts to deny the seizure of CITGO altogether.

[RP]

Where does the notion of Citgo being an essential piece for the Veny economy comes from anyway? It was a sound investment aimed at vertical integration over 40 years ago. From a creditor's perspective it is undeniably the most prized asset abroad. But a fundamental part of the country's oil industry it is most definitely not. Losing it this way would surely hurt, and bad. But a crushing blow to the economy seems to be a bit overblown statement.

[Brage Humphries]

CITGO is one of the few actually paying cash for Venezuelan oil. Venezuelan oil exports to other countries such as China and Russia are usually just taken as repayment for debt to these countries. The government needs this cash to operate. Without this cash, the country's economic situation would deteriorate even further.

[RP]

Understood, Brage. Yet wouldn't a non-PDVSA controlled CITGO (or any other refiner or client, for that matter) still pay (presumably in cash) for the same oil? I do not think the added value of CITGO comes from this side of the equation anyway, but rather from tapping in downstream and retail operations within Venezuelan crude oil products' main exporting market.

[Jordan P.]

Is there a way that the lack of National Assembly approval could be used as leverage for a restructuring? I mean, without actually invalidating the collateral pledge in PDVSA, isn't the possibility of a judgment invalidating the bond's collateral incentive to entice creditors to compromise?

[Meredith Bock]

I think it is important to look deeper into what should be considered a contract of “national public interest” because this is essential in determining whether the PDVSA 2020 bonds were properly authorized. One thing that remains unclear to me is whether the contract had to be entered into with the intent of affecting the national public interest, or whether the mere fact that there would be an effect on national public interest would be sufficient.

The argument here seems to be that since the PDVSA 2020 bonds were issued amid a humanitarian crisis and the decision to collateralize the bonds using an asset crucial to the country was made for purely political purposes, such a politically-motivated decision was a matter of “national public interest.” This argument implies that a contract of “national public interest” is one that has an effect on the public interest of the country, but was not necessarily entered into with the intent of creating that effect.

If it were true that any debt issuance with an indirect effect on Venezuelans was enough to be considered of “national public interest,” wouldn’t past bond issuances by PDVSA have needed National Assembly approval as well? After all, these issuances led to the extreme indebtedness that was a contributing factor in the crisis in the first place. I think it is important to understand whether an issuance with any effect on the “national public interest” is enough to require it to be approved by the National Assembly. However, the fact that Article 101 is rarely used seems to indicate that this may not be the case. With undeveloped case law on the subject, I’m not sure this is a question that really has an answer, but it will be crucial in Guaido’s attempt to disclaim the debt.

[N. Shah]

In lifting the District Court’s stay on the sale of Citgo shares, the U.S. Circuit Court of Appeals has given the go ahead to Crystallex’s seizure and sale of PDV-Holding shares. With no other mechanisms currently in place to protect Venezuela’s assets abroad, does this go to incentivize other creditors to hold out for a similar outcome in the PDVSA 2020? Or do they run the risk that the PDVSA 2020 bond validity and authorization questions do get unraveled and they end up losing the ability to seize their Citgo-Holding shares?

[Renxiang Wei]

I believe the lack of authorization from Venezuelan's legislature offers a valid defense for not honoring the PDSVA obligations, as Article 150 as already pointed out, especially with CITGO being the crown jewel of the nation's oil production and essential part of the hope to rebuild the crippling economy, which satisfied the requirement of "national public interest". The partial repayment earlier this year is not sufficient enough to be considered as evidence of adoption of the debt, especially since during the issuance and during the repayment period, wide spread protests were reported and sophisticated investors should or are expected to know this.
I agree with Mr. Brage Humphries on his take about the possible moves of U.S. court. Seizure of CITGO will essentially crush the Venezuelan economy and vanish all hopes of rebuild and repayment. A U.S. court may consider the dire consequence of a humanitarian crisis in Venezuela and prevent the seizure. And other foreign countries may pressure the Venezuelan company not to give up so quickly as well. As reported in the following two articles,

https://www.cnbc.com/2019/02/07/venezuela-china-and-russia-owed-debts-as-presidential-fight-rages.html
https://nationalinterest.org/blog/buzz/china%E2%80%99s-oil-backed-loans-venezuela-appear-headed-haircut-43992

Both China and Russia hold significant lending interests in Venezuela, and China's lending to Venezuela is not necessarily secured by collaterals. The seizure of CITGO may crush Chinese creditors' hopes of getting any payments back. Therefore the outcome of the case may also depends heavily on the political leaning of the president of Venezuela.

[Connor Colson]

In this situation, it may even be useful to look at the PDVSA debt as an "odious debt". In the most rudimentary definition a nations debt is considered odious when government leaders use borrowed funds to oppress their citizens. This principle is rarely utilized but often discussed as part of Customary International Law. This can be a defense for subsequent administrations, as both the National Assembly and the Government in Exile (lead by Juan Guido') have clearly evidenced their disapproval.

As stated in this article and the Project Syndicate analysis, Citgo is the primary source of foreign currency for a country with a massive need for it. Because enforcement of this bond would have sweeping humanitarian consequences its possible that NY courts will see the creditors as (1) knowingly borrowing from an illegitimate government, (2) opportunistically perpetuating the oppression of the populace. These points could support the court finding that enforcing this collateral would be disproportionate forfeiture, as the interests of an entire countries population is weighed against that of sophisticated debt buyers who knowingly took on a risk of repudiation.

(Project Syndicate Link: https://www.project-syndicate.org/commentary/venezuela-pdvsa-debt-default-creditor-risk-by-mitu-gulati-et-al-2019-10)

[Matt Costa]

The fact that Venezuela's national assembly didn't approve the PDSVA obligations seems to me at least to be enough of a moral justification for not honoring the debt payments. This is amplified by the fact that not only did the people not approve it, but they would be the ones dealing with the ramifications of the default. This would come in the form of losing CITGO, which would remove any hope of improving the economy in the near future. The people who would feel the effects of this would not be the bondholders. It would be the citizens of Venezuela. Further, taking CITGO, while lucrative at first would have long term effects in that it would likely put an end to repayment and diminish further bond prospects. The decision of the court, and by extension, the decision of which jurisdiction will be utilized is extremely important as it will dictate whether the debt payments are enforced or not.