Can Creditors Seize CITGO? Enforcing the PDVSA 2020 Bond Collateral

Mark Weidemaier & Mitu Gulati

Writing with Ugo Panizza, we have a piece out today on Project Syndicate (Should Creditors Pay the Price for Dubious Bonds?) discussing the collateralized bond issued by Venezuelan state oil company PDVSA (the PDVSA 2020 bond). We have written here previously about the bond as well. In 2016, when PDVSA was near default, it conducted a debt swap in which investors exchanged short-maturity bonds for the longer-maturity PDVSA 2020. To sweeten the deal, the PDVSA 2020 bond was backed by collateral in the form of a 50.1% interest in CITGO Holding, the immediate parent company of U.S. oil refiner CITGO Petroleum.

A payment of nearly $1 billion is coming due in the next few weeks on the PDVSA 2020 bond. The Maduro regime—no longer recognized as the legitimate government of Venezuela—can’t pay it. And the government-in-exile led by Juan Guaidó—though it desperately wants to retain control of CITGO—presumably can’t afford to pay. If there is a default, and bondholders seize the collateral, the loss of CITGO may significantly disrupt Venezuela’s ability to recover from its current economic and humanitarian catastrophe. To be sure, the prospects of recovery are dim while Mr. Maduro remains in power, but if he leaves, the loss of CITGO will be a major blow.

The Project Syndicate article describes how, under Venezuelan law, the National Assembly must approve contracts of national interest. That didn’t happen here. Venezuela might therefore challenge the issuance of the PDVSA 2020 bond, and the grant of collateral, as lacking proper authorization under Venezuelan law. Ugo and we examine the potential justification for such a challenge at Project Syndicate.

Here, we focus on a more wonky question: Is the validity of the PDVSA 2020 bond and the pledge of collateral to be judged under Venezuelan law or New York law? And would the outcome change depending on which law governs? The answers turn out to be more complicated than one might think. But, given the court battle that we expect, rather important.

To understand the complications, we need to start with some background on governing law clauses, before delving into the ones in the PDVSA 2020 bond.

Emerging market sovereign bonds issued in international markets almost always include clauses providing that the bond will be governed by foreign law—typically New York or English law. Without a governing law clause of this sort, in a lawsuit by an investor, the tribunal would have to undertake a conflicts of laws analysis to decide which jurisdiction’s law to apply. And that can be an invitation into quicksand if the tribunal has to go issue by issue in terms of which law governs.

As a matter of logic, though, even if New York or English law governs most issues relating to a sovereign bond, one might think that some matters will necessarily depend on the sovereign’s own law. An example is whether the bond was authorized appropriately by the relevant legislative bodies of the sovereign. Surely local law governs this question. After all, why would New York or English law have anything to say on the subject?

Indeed, when governing law provisions in sovereign bonds designate foreign law, they often add an explicit “carve out,” which expressly states that matters of “authorization and execution” will be governed by the issuing government’s local law. We base this on an examination of 150 foreign-law governed bonds, 51% of which had such a carve out.

How should one understand the remaining foreign-law bonds—the ones without an explicit carve out for questions of authorization and execution? Is it that the lawyers who documented the deal viewed it as obvious that such matters would be governed by local law? Or is it that the sovereign and its creditors decided to have foreign law determine these matters?

We have had a number of conversations about this with sovereign debt lawyers, and many have expressed the view that matters of authorization and execution are always determined by local law, unless the bond explicitly says otherwise. Indeed, some thought we were rather silly to think that sovereigns and their investors might negotiate over these provisions.

Still, we don’t pretend to have conducted a representative survey of the lawyers. Plus, as a matter of plain reading, a clause that designates English or New York law as governing without making any exceptions seems different from a clause that expressly exempts questions of authorization and execution. That difference in drafting becomes particularly important in a dispute over whether the bond was properly authorized.

So, let us turn to the Venezuelan bonds. Venezuela’s sovereign bonds, in their Fiscal Agency Agreements, have an explicit carve out for authorization and execution. The typical governing law clause reads as follows (with our emphasis):

THIS AGREEMENT SHALL BE GOVERNED BY, AND INTERPRETED IN ACCORDANCE WITH, THE LAWS OF THE STATE OF NEW YORK WITHOUT REGARD TO PRINCIPLES OF CONFLICTS OF LAWS. AUTHORIZATION AND EXECUTION OF THIS AGREEMENT BY THE ISSUER, HOWEVER, SHALL BE GOVERNED BY THE LAWS OF THE REPUBLIC OF VENEZUELA.

The clause seems clear. All issues are to be governed by New York law (even if New York conflicts of laws rules would point to the law of another jurisdiction), with the exception of questions concerning the authorization and execution of the bond, which are to be governed by Venezuelan law.

So far, so good. That is, until we get to the PDVSA 2020 bond. As anyone who follows Venezuelan debt knows, the fact that Venezuela’s foreign currency earnings are almost all derived from sales of oil means that the oil company’s credit is essentially the same as the sovereign credit. So, one might expect the bond contracts to be essentially the same, including as to the governing law. Strangely, they are not, and we have not heard any explanation for the difference. The governing law provision in the indenture for the PDVSA 2020 bond says (to our knowledge):

THIS INDENTURE AND THE NOTES SHALL BE CONSTRUED IN ACCORDANCE WITH, AND THIS INDENTURE AND THE NOTES AND ALL MATTERS ARISING OUT OF OR RELATING IN ANY WAY WHATSOEVER TO THIS INDENTURE AND THE NOTES (WHETHER IN CONTRACT, TORT OR OTHERWISE) SHALL BE GOVERNED BY, THE LAWS OF THE STATE OF NEW YORK WITHOUT REGARD TO THE CONFLICTS OF LAW PROVISIONS THEREOF (OTHER THAN SECTION 5-1401 OF THE NEW YORK GENERAL OBLIGATIONS LAW).

This provision differs in a number of ways from the governing law clause above. (Confusingly, it also differs from the description of the same clause in the PDVSA 2020 bond prospectus, but that is a different can of worms, and we will leave the lid closed.) From our perspective, the biggest difference is that this bond does not expressly state that Venezuelan law will govern questions concerning the authorization and execution of the bond. Indeed, it could be read to designate New York law for pretty much every issue one can imagine (“all matters arising out of or relating in any way whatsoever to this indenture and the notes…”). Whether it will be interpreted that way is another question. To resolve that issue, a judge might have to decide whether the lawyers drafting the PDVSA bond simply thought it too obvious to specify that local law would govern matters of execution and authority; whether the omission of an express carve out was inadvertent; etc… (As an aside, different law firms drafted the two contracts.)

Let us assume that the judge decides to focus only on the words of the contract and rules that New York, rather than Venezuelan, law will govern any challenge to the PDVSA 2020 bond. How should a court think about the fact that the National Assembly did not approve the issuance? As an initial matter, we are uncertain how to characterize the question before the court. Is it a question of PDVSA’s capacity to borrow? (A person under eighteen years old, for example, typically lacks capacity to enter a contract.) Or is this a question of whether the representatives who purported to commit PDVSA to the bond issuance had authority to do so?

However these questions are resolved, there is an argument, even under New York law, against enforcement of the PDVSA 2020 bonds. The National Assembly’s refusal to approve the bond was widely reported at the time and presumably well-known by investors before the swap. And while, in 2019, the Guaidó-led government in exile made a smaller payment on the PDVSA 2020 bond, it did so under protest, making clear that it viewed the bond as illegitimate but couldn’t afford to see the country lose CITGO. So the payment would not likely be deemed a ratification of the bond (and, in any event, it is not at all clear that a bond issued without proper domestic authorization can be ratified).

With Ugo, we discuss on Project Syndicate other reasons to question the enforceability of the PDVSA 2020 bond, and we won’t repeat that discussion here. For the Venezuelan people, however, the loss of a crucial national asset would compound the misery that has already resulted from Mr. Maduro’s extended stay in power.