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

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.