Marblegate and the Use of Exit Consents to Restructure (Venezuelan) Sovereign Debt
This is a joint post by Mark Weidemaier and Mitu Gulati.
About a decade and a half ago, exit consents were a big deal in sovereign debt restructuring. At the time, sovereign bonds governed by New York law required unanimous bondholder approval before any modification to the payment terms of the bonds. The result was that creditors could easily hold out from a restructuring. Needing to mitigate the holdout problem in Ecuador in 2000, sovereign debt guru Lee Buchheit borrowed a technique from corporate bond restructuring practice in the United States. There, the Trust Indenture Act forbids out-of-court bond exchanges that modify "the right of any holder ... to receive payment ... or to institute suit" without the consent of each affected bondholder. To oversimplify, Buchheit leveraged the fact that other terms of the bonds could be amended with a lesser vote, often a simple majority or 66.67% of the bonds. This meant that potential holdouts risked having key protections stripped from their bonds in a restructuring that won the approval of a majority of bondholders.
Ecuador used this exit consent technique in 2000, as did Uruguay in 2003 and the Dominican Republic in 2006. Yet later developments seemed to relegate exit consents to the historical dustbin. First, virtually all foreign-law sovereign bonds issued after 2003 included collective action clauses (CACs), which allowed a super-majority of bondholders to modify even payment terms. Second, a number of judicial opinions appeared to rein in the use of exit consents, viewing the technique as potentially coercive. Thus, after a key English case, Anna Gelpern queried: "Exit Consents Killed in England?"
Recent cases pending before federal courts in New York raised the possibility that the exit consent technique would be limited even further. About a month ago, the Second Circuit issued an opinion in one of these cases: Marblegate. The case has attracted a lot of attention, and the Wall Street Journal and Financial Times have good background. In a nutshell, the issue in Marblegate was whether a bond exchange can be so coercive that it functionally impairs the right "to receive payment ... or to institute suit," even though, as a formal matter, the exchange leaves those rights intact.
Marblegate implies that the answer is "no," although the court did not say this in such explicit terms. It did, however, interpret the TIA's prohibition as limited to "formal indenture amendments to core payment terms" (and modifications that prevent bondholders from "initiating suit"). If taken literally, this view gives issuers a great deal of freedom to play hardball in structuring a bond exchange. The issuers most likely to value this freedom are sovereign governments (e.g., Venezuela) and their instrumentalities (e.g., PDVSA).
Venezuela's bonds are not subject to the TIA (and do not even involve a trust indenture). Nevertheless, some of its older bonds require the consent of each bondholder to modify core payment terms (and a few other terms, which we'll call "Reserved Matters"). The bonds thus replicate the TIA's prohibition, but as a matter of contract rather than statute. Moreover, while Venezuela's newer bonds have collective action clauses allowing holders of a super-majority of the outstanding debt (either 75% or 85%) to impose restructuring terms on dissenters, these CACs operate series-by-series, which makes it relatively easy for dissenters to block a restructuring vote. All Venezuelan bonds, however, allow modifications to non-Reserved Matters at a lower voting threshold. In any Venezuelan restructuring, then, exit consents will likely play a prominent role, given the country's inability to rely on CACs. As noted earlier, in 2000 Ecuador conducted an exchange in which participating bondholders voted to remove cross-default and negative pledge clauses, and to delist the old bonds. (Venezuela's case is complicated by the fact that its newer bonds expand the list of Reserved Matters to require super-majority approval to change some non-payment terms, such as clauses specifying the governing law.) Although instrumentalities such as PDVSA sometimes issue debt with CACs, PDVSA's bonds likewise incorporate the TIA's prohibition, requiring each bondholder to consent to any modification that impairs the right "to receive payment ... or to institute suit." Thus, it too may turn to exit consents as a restructuring tool.
The question is what lessons Marblegate teaches about the use of exit consents in the context of bonds issued by foreign governments and their instrumentalities. The TIA imposes no limits whatsoever on Venezuela's use of exit consents. Those limits, whatever they are, stem from the bond contract and from New York law (which governs the bonds). Our sense, however, is that a foreign sovereign should have more rather than less freedom to use exit consents, even if it presents bondholders with a choice that is somewhat coercive. After all, in the domestic corporate debt context, the alternative to exit consents is bankruptcy. The TIA represents a policy in favor of conducting collectively-binding workouts under the supervision of a bankruptcy court. But of course there is no bankruptcy fallback for sovereigns. If a sovereign is to implement a collectively-binding restructuring, contractual tools are its only option. We don't doubt that New York law imposes some limits on the ability to conduct a coercive debt exchange--whether under the duty of good faith or under some other doctrine--but we do not see why those limits should be more draconian than those imposed by the TIA.
For PDVSA the question is a bit more complicated. Whether or not it was required to comply with the TIA (section 304 exempts securities "issued or guaranteed by a foreign government or ... instrumentality thereof," though we gather that some lawyers interpret this exemption narrowly), PDVSA incorporated the TIA's precise language into its bonds. Thus, in examining the legality of any PDVSA exchange offer, one might expect a court to look to Marblegate for guidance. The Second Circuit's reasoning may not prove very helpful, as the court based its ruling on an extensive inquiry into the TIA's legislative history. To the extent the limits on PDVSA's right to conduct exchange offers stem from contract law, discussion of the TIA's legislative history isn't all that relevant. But the result in Marblegate certainly suggests PDVSA will have substantial freedom to conduct a debt exchange, so long as it does not amend "core payment rights" or bar bondholders from "initiating suit." It does not take too much imagination to envision an exchange offer that forces PDVSA bondholders to choose between (a) accepting new bonds with less favorable payment terms and (b) retaining old bonds that have been stripped of many of their protections and that represent claims against an entity that has been stripped of its right to exploit Venezuela's oil reserves. While not exactly an appealing choice, we suspect many bondholders would agree to restructure.
In any event, Marblegate is not the last word on these questions. It was a 2-1 decision, with a robust dissent. Other cases will shed further light on the utility of the exit consent technique. But for now, sovereign borrowers and their financial advisors may be breathing a sigh of relief.