As sovereign borrowers and their creditors know all too well, the legal framework governing their respective rights and obligations (the so-called international financial architecture) lacks an effective means to enforce payment in most circumstances or to modify payment obligations when the debtor is unable to honor the original terms of its debts. The recent case of Argentina exemplifies both of these shortcomings. Venezuela’s debt instruments and debt management techniques developed over time nonetheless hold out the promise that the country may forge a path to a successful rearrangement of its debts when a government committed to sound economic policies and fair treatment of its creditors is ready to address the issue,
The lukewarm reception of PDVSA’s recent debt exchange and the terms of the exchange itself – which by some measures worsened Venezuela’s overall financial position even as it provided a modest amount of short-term relief – reflect the current government’s lack of a coherent strategic approach to the country’s financial problems. Of immediate concern to financial creditors is how Venezuela will meet its substantial debt service obligations in the short and medium term. Today, the Republic and PDVSA each has more than $30 billion of bonds outstanding, and the public sector has well over $100 billion of additional liabilities in the form of loans, guarantees and amounts payable to suppliers and judgment creditors.
Venezuela may have the willingness to pay (although some believe that, were it not for fear that valuable PDVSA assets and the proceeds of oil exports would be seized by creditors, Venezuela would view default in a more attractive light), but the market consensus and the view of many leading economists is that Venezuela does not have the capacity to pay its debts as they become due in the medium term without some measure of relief.
Debt relief may be as modest as a reprofiling – that is, an extension of maturities – or it may encompass a deeper restructuring in which principal is reduced (a haircut) and interest rates are modified. In either event, a modification of the terms of the Republic’s and PDVSA’s bond terms (whether modest or radical and no matter how it is carried out) will require the consent of a substantial majority of creditors. The obverse is that a significant minority of creditors may withhold their consent.
For purposes of this paper, we consider a situation in which the government of Venezuela – in all likelihood a new government – seeks in good faith to negotiate a reprofiling or restructuring of its debt in order to achieve debt sustainability while at the same time committing to pursue sound economic policies and treat its creditors fairly. We note that bondholders have differing views as to the treatment of PDVSA’s bonds and those issued by the Republic, with some arguing that PDVSA’s debt can and should be paid in full and on time (after all, the oil revenues belong to it, and the PDVSA bonds have no collective action clauses ( “CACs”)) even if the government’s debt may need to be restructured, and others arguing exactly the opposite (the oil belongs to the nation, not to PDVSA, and PDVSA’s right to exploit it can be withdrawn at any time – a risk factor highlighted in the offering documents for PDVSA bonds). For a number of reasons based on precedent and policy we assume (and would advocate) that PDVSA and government bonds will be treated alike.
As sovereign debt aficionados know, in the absence of aggregated collective action clauses that would allow say 2/3 or 3/4 of a country’s creditors to bind all others, there is no contractual or legal mechanism to compel would-be holdouts to join with consenting creditors in accepting a deal that does not appeal to them. And although the Argentina example may be distinguishable from that of Venezuela, the fact that Argentina’s holdout creditors won significantly better treatment than those who signed onto the country’s debt exchanges provides an added incentive for creditors seeking to free ride. PDVSA’s bonds are issued under the United States Trust Indenture Act and have no CACs, which are not allowed under that statute. All but approximately $1 billion of the outstanding government bonds do have collective action clauses that allow 75 percent of the holders (85 percent in the case of a single $1 billion issue) to modify payment terms and bind non-consenting holders, but the government must obtain the required majority separately from holders of each bond issue. This is not easy to do, as aggressive holders, alone or in concert with others, can acquire blocking majorities in individual bond issues, thus scuttling any attempt to restructure those bonds. This is what happened in the case of Greece’s 2012 restructuring where €6 billion of bonds without aggregated CACs could not be restructured for that very reason.
Assume that Venezuela proposes a series of bond exchanges that are supported by a sound debt sustainability analysis and attract the voluntary participation of a substantial mass of bondholders as well as official financing institutions and friendly governments. What tools are available to Venezuela to secure a sufficient level of creditor participation to carry out a successful restructuring? By successful restructuring we mean in this context a level of participation that is sufficient to achieve the desired result in terms of debt relief and that will satisfy participating creditors that they are not bearing more than their fair share of the burden. (We do not address here the treatment of non-consenting creditors, but we find compelling the notion of treating them no better than participating creditors, notwithstanding the inevitable litigation risks, and would hope that the official sector would support this approach.) The tools to encourage participation in the exchanges would consist, in the case of government bonds, of CACs and possibly exit consents, and, in the case of PDVSA, exit consents, the government’s ability to modify PDVSA’s current exclusive right to exploit the country’s hydrocarbon reserves and a possible pre-packaged bankruptcy. Let us consider each in turn.
For the government bonds, the exchange offers would seek to garner the support of 75 percent of holders of each issue (by value), which if attained would result in the mandatory exchange of the entire issue. Since important bond terms can be modified with the consent of only 66-2/3 percent of holders, and since holders of a particular issue might be willing to exchange their bonds even if the CAC threshold for their series is not met, the exchange offer could be accompanied by a consent solicitation inviting holders to agree to modify the terms of the existing bonds by deleting certain protective provisions, thus worsening the position of bondholders that opt not to exchange their bonds. In this case, the exit consent would also improve the prospect of triggering the CAC, as the threat of successful modification of the terms of the bonds will encourage bondholders to join the exchange. Provisions that could be deleted or modified with a 66-2/3 percent vote would include the darling of Argentine holdouts – the pari passu clause – the negative pledge clause and the waiver of sovereign immunity. In particular, Venezuela could agree to grant security to all exchanged bonds and not to bonds not exchanged.
In the case of the PDVSA bonds, Venezuela has a larger palette of options. Although these bonds do not have CACs, they can be amended through exit consents approved by a simple majority of holders of each issue. Here, exit consents can be used not only to modify the pari passu, negative pledge and waiver of sovereign immunity clauses, but also to modify or eliminate events of defaults and change the governing law. The Venezuela and PDVSA bonds are (with few exceptions) governed by New York law and, as noted above, the PDVSA bonds are subject to the Trust Indenture Act. An issuer’s ability to modify bond terms through exit consents is not unfettered as a legal matter. Nonetheless, there is room to create powerful incentives to participate in a bond exchange.
The government has other options as well in the case of PDVSA. First, the government may modify PDVSA’s legal right to produce or export the nation’s oil and gas or may favor production by private parties. There may be limits to what the government can do under applicable bilateral treaties, but there is ample room to limit PDVSA’s role, and the offering documents for the bonds warned prospective investors of this possibility.
Finally, as a private company under Venezuelan law, PDVSA may be subject to bankruptcy protection under Venezuelan and U.S. law. Here we have in mind a voluntary filing in aid of a debt exchange agreed with not less than 66-2/3 percent of bondholders – in other words, a pre-packaged bankruptcy. The purpose of the bankruptcy filing would be solely to require the participation of the not more than 1/3 of creditors who did not sign on to the plan in the first place. And in this case, unlike exit consents and CACs, voting would not be on a series-by-series basis but would consist of a single vote of all PDVSA bondholders. We are mindful of the many issues relating to PDVSA’s eligibility to seek bankruptcy protection, but we believe that under the circumstances envisaged there is a good chance that Venezuela could find a way to avail itself of this powerful tool.
The tools explored above do not fill all of the gaps from which the current international financial system suffers, but they may well be adequate to enable Venezuela to defeat the efforts of would-be free riders to impede a fair and reasonable resolution of the country’s debt problems.
This post comes to us from Mark A. Walker, a managing director and the head of sovereign advisory at Millstein & Co., and Jill Dauchy, a managing director at the firm.