Strip, Swap, Restructure

Mitu and I have been posting jointly of late about restructuring options for PDVSA and Venezuela. Alas, I’ll have to write this one myself, because it’s time to talk about an idea that Mitu and Lee Buchheit have proffered for restructuring much of PDVSA’s debt. Their proposal has important similarities to one by Adam Lerrick (also described briefly here and in more detail in the Financial Times), so I’ll cover both.

Both proposals are laudably clear-eyed about some fundamental aspects of the Venezuelan debt crisis. First, if it ever made sense to view PDVSA and the Republic as separate credits, that time is long past. Second, for a restructuring plan to be feasible, it must simplify an enormously complicated debt stock and encompass more than bond creditors. Thus, while neither creates a mechanism for encompassing all of PDVSA’s liabilities, both the Lerrick and Buchheit/Gulati proposals envision a restructuring of both bond debt and the pesky promissory notes that PDVSA has issued to trade creditors. The latter instruments are especially problematic from a restructuring perspective, because they lack contract-based mechanisms for modifying their terms. Finally, both proposals recognize that something must be done to protect oil-related assets, including future receivables, from holdouts.

These shared assumptions result in similar proposals. The difference is in the details, which turn out to be important. Let’s call the Lerrick proposal Strip, Swap, Restructure.

Strip, Swap, Restructure

In a nutshell, Lerrick proposes (i) that all of PDVSA’s Venezuelan assets be transferred to the Republic; (ii) that the Republic withdraw PDVSA’S concession to exploit hydrocarbon reserves; (iii) that PDVSA bond- and note-holders be offered the opportunity to exchange their instruments for new bonds, with identical terms, issued by the Republic; and (iv) that the Republic then launch a restructuring of all of its debt. To protect oil-related assets, Lerrick suggests requiring payment and transferring title in Venezuela. Buyers will want a price discount, of course. But hey, judgment-proofing ain’t free.

Lerrick notes that holdouts will retain their claims against PDVSA. But of course, PDVSA will not exactly be an inviting litigation target. He also notes that holdouts may ask courts to treat the government as the successor to PDVSA’s debts. Lerrick dismisses this risk, opining that any holdout who won on this argument would be “in the exact same position as if it had accepted” the Republic’s exchange offer.

There is a lot to like in this proposal. Lerrick is an extremely well-respected economist, and his views will carry great weight at Treasury. I also suspect he is less interested in legal details than in the basic structure of the proposal. Still, I’m a bit hung up on the part about the holdouts.

A PDVSA bondholder who participates in the exchange offer will have a claim against the Republic under the new bonds. The Republic has no money and intends to restructure these bonds. It will presumably do that by proposing another exchange, only this time participating bondholders will also vote to modify the bonds they are exchanging in unpleasant ways. This is the classic exit consent (and Mitu, if he were here, would want you to know how much he loves exit consents!). If the new bonds issued by the Republic are otherwise identical to the exchanged PDVSA bonds, they will not have CACs and will bar any "impairment" of a non-consenting bondholder’s right to payment or to institute suit. But even if these limitations remain in place, it’s relatively easy to envision a subsequent exchange offer successfully restructuring the Republic’s bond debt.  

I’m not sure I share Lerrick's confidence that holdouts will be no better off than participants in the initial exchange of PDVSA for Republic bonds. To begin with, it seems to me that this proposal essentially guarantees that courts will pierce the corporate veil and hold the Republic liable for PDVSA’s debts. Whatever one thinks about the withdrawal of the concession, the proposal envisions a straight-up transfer of PDVSA assets to the government. That’s an easy case for veil piercing.

Once PDVSA's bond liabilities are imputed to the Republic, it's hard for me to see holdouts as on equal footing with holders of Republic bonds. The modification provisions in the new Republic bonds will be useless against holdouts, who won’t own them. Nor could the Republic invoke the modification provisions in the holdouts’ own (PDVSA) bonds. Even if the Republic could claim the benefit of these provisions (possible, but not certain), who would vote in favor of a modification? Bondholders who exchange PDVSA bonds for Republic bonds that will surely be restructured signal their willingness to, well, restructure. It’s easy to imagine a majority–even a large majority–subsequently accepting a reasonable restructuring proposal by the Republic. But PDVSA bondholders who hold out are in it for the long haul. They’ll have non-restructurable claims for full principal and accrued interest against the shambling husk of PDVSA, against the government itself, and potentially against any entity that receives the oil and gas concession currently enjoyed by PDVSA. Yes, the government can take steps to shield oil-related assets from creditors, but that’s neither here nor there. PDVSA can take those steps now. And even if the government effectively shields oil-related assets, it will have to worry about holdouts lurking in the shadows every time it tries to access foreign commercial and capital markets.

As I mentioned, Lerrick may not be wedded to the details of his proposal. He is primarily interested in protecting oil-related assets and in simplifying the debt stock before a restructuring. The plan is elegant and may well provide the framework for a successful restructuring. But I’m not convinced that it effectively counters the risk of holdouts.  

Pledge, Swap, Restructure

To understand the Buchheit/Gulati proposal, just replace “Strip” with “Pledge.” To mitigate the risk of holdouts, Lee and Mitu take a deep dive into PDVSA’s bond contracts. My first-year law students sometimes enter my Contracts class believing that contracts exhaustively specify the parties’ rights and obligations, leaving few gaps to fill or ambiguities to interpret. I spend much of the semester teaching them otherwise, when I’d really just like to introduce them to Lee and Mitu. The drafters of PDVSA’s bonds probably didn’t envision quite this scenario, but Lee and Mitu proffer an entirely reasonable interpretation of a particular clause. Actually, sub-part 23 of that clause. The clause defines Permitted Liens (i.e., liens that PDVSA can create despite the negative pledge clause in the bond) to include:

(23)  Liens in favor of the Venezuelan government or any agency or instrumentality … to secure payments under any agreement entered into between such entity and the Issuer …”

Like Lerrick's proposal, the Buchheit/Gulati proposal envisions that PDVSA bondholders will swap their bonds for new ones issued by the Republic. To encourage participation, they too want to turn PDVSA into an uninviting litigation target. But rather than strip away its assets, they propose that PDVSA grant the Republic a security interest in everything it owns. With the Republic assuming much of its debt, PDVSA will promise to repay whatever the Republic spends. (Whether it actually repays is another question, but of course failure to do so will make the arrangement look a bit of a sham.) The pledge of security will back that promise, while also creating a senior lien to effectively prevent holdout creditors from seizing PDVSA assets.

Arguably, not much distinguishes the Lerrick and Buchheit/Gulati proposals. Isn’t this asset stripping by another name? Well, perhaps not. By finding express contractual authority for their transaction, Lee and Mitu may mitigate the risk that the Republic will be treated as PDVSA’s alter ego. Moreover, the transaction bears at least some resemblance to an ordinary commercial loan.

On the other hand, if a court views PDVSA’s reimbursement obligation as a pretense, existing only to justify the lien, will it really allow the subordination of PDVSA’s bond creditors? More generally, if a court concludes that PDVSA is Venezuela’s alter ego, won’t it simply disregard the lien? Lee and Mitu recognize this risk and, to mitigate it, suggest that Venezuela should “promptly restore a degree of independence to PDVSA.” That seems like good advice, for all kinds of reasons. Like, for instance, creating a functional oil company. But when it comes to defeating the claims of PDVSA's current creditors, I worry that the horse is out of the barn.

PDVSA’s creditors argue, with some force, that Venezuela has used its control as shareholder (and regulator) to enrich itself at their expense. Examples include requiring massive contributions to social programs, orchestrating large debt-fueled dividend payments, and other shenanigans. If these acts are problematic, it isn’t clear to me that Venezuela can protect itself by reforming its relationship to PDVSA now. To be sure, the decision to disregard a corporation’s separate legal status is an equitable one. If Venezuela starts acting more like an ordinary shareholder, perhaps the equities will weigh less heavily in favor of imputing PDVSA’s liabilities to the Republic. This may be what Lee and Mitu have in mind, and I acknowledge that the argument has some force.

But it’s quite easy to see matters differently. Courts tend to disregard the corporate veil when a shareholder uses its control over the corporation to elevate itself in priority over corporate creditors. If you ask a creditor like Crystallex, that’s just what Venezuela has done. Indeed, the argument retains force even if a large majority of PDVSA bondholders participate in the swap envisioned by Lee and Mitu. Perhaps Venezuela’s abuse of the corporate form has left them with few better options. If that’s so, I don’t see why it should matter if Venezuela suddenly decides to straighten up and fly right. 

Of course, I’m telling the story in the light most favorable to creditors; I don’t mean to prejudge the merits of the veil piercing arguments. The point is only that Lee and Mitu don’t fully engage with the risk that a court might view this transaction as a sham or might disregard the corporate partition separating PDVSA from Venezuela. I worry that the risk is a substantial one. The fact that they bury this discussion in a footnote (on p. 5) makes me wonder whether they feel the same way.

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Enough about veil piercing and holdouts. But while I’m on a roll… One of the best features of the Lerrick and Buchheit/Gulati proposals is that they are simple, easy-to-explain solutions to an extraordinarily complex problem. That’s no faint praise. Any restructuring will require significant creditor buy-in, and creditors aren’t likely to buy in if they can barely understand the mechanics of what the government proposes. Complexity also works to the advantage of holdouts, who can exploit ambiguities in a lengthy, convoluted restructuring process.

Yet Venezuela has created such a mess that many questions remain unanswered. Here’s one of them: Rumor has it that many PDVSA bonds and promissory notes were issued with principal amounts that were … a bit on the high side? The so-called Hunger Bonds are an example, but there are reportedly others. In any event, the principal purportedly due at maturity bears little relation to the amount actually paid at issue. It’s reasonable to suppose a number of these wound up in the hands of likely holdouts. What will happen to these bonds? If ever there were an argument for treating sovereign debt as illegitimate, or for disallowing claims for the difference between the face value and the issue price, it applies here. But it’s an open question whether courts applying New York law will recognize the difference between these bonds and others issued under normal market conditions. Does it matter whether a new Venezuelan government is in place? Will creditors holding these bonds be treated differently in a restructuring? My sense is that many market participants are ignoring questions like these for now, but that they may become more important when restructuring negotiations begin in earnest.