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PDVSA’s 2020 Bonds: When and Why Does Venezuelan Law Matter?

posted by Mark Weidemaier

Mark Weidemaier and Mitu Gulati

In 2016, the Maduro government bought some time through a debt exchange in which holders of maturing bonds issued by state oil company PDVSA swapped them for new bonds due in 2020. The new bonds were collateralized by a 50.1% interest in the U.S. parent company of Citgo. Now that the U.S. no longer recognizes the Maduro administration, the new Venezuelan government sued in the Southern District of New York asking to invalidate the bonds and the collateral pledge. It points to Venezuelan law requiring legislative approval for contracts in the “national public interest,” which didn’t happen here. For background, see our posts from last October, here and here.

The initial briefs have been filed, and not surprisingly the parties disagree about the relevance of Venezuelan law. The PDVSA 2020 bonds are governed by New York law. Venezuela argues that this does not matter, that Venezuelan law determines whether the bonds are valid. The indenture trustee argues that Venezuelan law is irrelevant, that New York law is all that matters, and that under New York law the bonds are enforceable. We’ve seen similar disputes a lot of late, including in connection with debt issued by Ukraine, Mozambique, and Puerto Rico. A government issues foreign-law debt that it later claims was unlawful under its own law. What law governs the dispute?

We have been mulling this question for some time now. At first, we thought it was straightforward, and we suspect many market participants feel the same way. But it is more complicated than a simple foreign versus domestic binary. The end result is this paper, Unlawfully-Issued Sovereign Debt.

In the article, we explain why foreign law does not, in fact, govern every issue raised in a dispute like the one over the PDVSA 2020 bonds. We also explain why this does not necessarily help PDVSA. Assuming the bonds were unlawful under Venezuelan law, the basic problem is that New York law will determine the consequences of the violation. To be clear, the bonds might or might not be enforceable. But that question will be determined by New York law.

We also explain why the text of a bond’s choice-of-law clause can make a difference in cases like this. As it turns out, many bonds currently in the market—but especially bonds under New York law—include language that may expose investors to greater risk. The paper documents the frequent use of “carve outs” that could be interpreted to require the application of the sovereign’s local law to a wide range of issues. Indeed, one of the arguments made by the indenture trustee in the PDVSA 2020 litigation is that the bonds do not include these carve outs (which, in the trustee’s view, means PDVSA meant to have New York law govern everything). These carve outs potentially undermine the protection ostensibly offered by an international bond.

We are skeptical that the carve outs were intended to have this effect. Our cynical take is that the carve outs are essentially meaningless—that drafters did not intend foreign law contracts with carve outs to mean anything different than contracts without carve outs. But there is still a risk that courts will assume that the extra words must add meaning.

Here is the full abstract to the article:

In 2016, its economy in shambles and looking to defer payment on its debts, the Venezuelan government of Nicolás Maduro proposed a multi-billion dollar debt swap to holders of bonds issued by the government’s crown jewel, state-owned oil company Petroleós de Venezuela S.A. (“PDVSA”). A new government now challenges that bond issuance, arguing it was unlawful under Venezuelan law. Bondholders counter that this does not matter—that PDVSA freed itself of any borrowing limits by agreeing to a choice-of-law clause designating New York law.

The dispute over the PDVSA 2020 bonds implicates a common problem. Sovereign nations borrow under constraints imposed by their own laws. Loans that violate these constraints may be deemed invalid. Does an international bond—i.e., one expressly made subject to the law of a different jurisdiction—protect investors against that risk? The answer depends on the text of the loan’s choice-of-law clause, as interpreted against the backdrop of the forum’s rules for resolving conflict of laws problems.

We show that the choice-of-law clauses in many international sovereign bonds—especially when issued under New York law—use language that may expose investors to greater risk. We document the frequent use of “carve outs” that could be interpreted to require the application of the sovereign’s local law to a wide range of issues. If interpreted in this way, these clauses materially reduce the protection ostensibly offered by an international bond. We explain why we think a narrower interpretation is more appropriate.

Comments

Without addressing the specifics of the Venezuelan bonds, doctrines of express representation and estoppel may also play a role. As your paper notes, it is market practice for the managers/underwriters to obtain legal opinions from both local and international counsel for the issuer confirming inter alia(i) due authorization, execution and delivery of the bonds, the indenture and the subscription/purchase agreements, etc., (ii) that those instruments are legal, valid and binding, (iii) that all applicable govt approvals have been obtained and are in effect, and (iv) non-contravention of applicable law. For sovereign issues, the signatory of the local law opinion is often a senior legal officer of the State, which creates further reliance circumstances. Moreover, under the subscription/purchase agreements between the issuer and the initial bond purchasers, the issuer will make express representations and warranties to the same effect and, at financial close, a senior officer of the issuer will execute and deliver a "bringdown" certificate confirming those representations and warranties as of the closing date. A variety of legal doctrines such as express representation and estoppel operate to undermine an issuer's later argument that those representations and warranties, confirmed by legal opinions, are not capable of being relied upon by their beneficiaries.

Regards,

MK

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