Should cred­i­tors pay price for du­bi­ous bonds?

The Korea Times - - OPINION - By Mitu Gu­lati, Ugo Panizza, and Mark Wei­de­maier Mitu Gu­lati is a pro­fes­sor of law at Duke Univer­sity. Ugo Panizza is pro­fes­sor of in­ter­na­tional eco­nomics and Pictet chair at the Grad­u­ate In­sti­tute of In­ter­na­tional and De­vel­op­ment Stud­ies in Geneva. Mark

DURHAM/GENEVA/CHAPEL HILL — In late Oc­to­ber, Venezuela is likely to de­fault on a $913 mil­lion pay­ment on a key bond. Be­cause the coun­try has al­ready de­faulted on most of its debt, one might be tempted to re­gard an­other missed pay­ment as no big deal.

But this bond, is­sued by the na­tional oil com­pany Petroleos de Venezuela, S.A. (PDVSA), and re­ferred to as PDVSA 2020, is backed by juicy col­lat­eral: a con­trol­ling stake in Venezuela’s eco­nomic crown jewel, United States-based re­finer CITGO.

Or­di­nar­ily, un­paid bond­hold­ers could tell the bond trustee to seize the col­lat­eral. But, given its du­bi­ous prove­nance, the PDVSA 2020 is no or­di­nary bond. It was is­sued in 2016, when PDVSA was close to de­fault. To buy time, the com­pany swapped short-ma­tu­rity bonds for this longer-ma­tu­rity one. In ex­change, cred­i­tors re­ceived col­lat­eral in the form of a 50.1 per­cent in­ter­est in CITGO’s par­ent com­pany.

The trans­ac­tion was un­usual in at least one re­spect. The Venezue­lan Con­sti­tu­tion re­quires the coun­try’s Na­tional Assem­bly to ap­prove con­tracts of na­tional in­ter­est. But the op­po­si­tion-con­trolled leg­is­la­ture did not ap­prove this bond is­sue, which it un­doubt­edly viewed as an at­tempt by Pres­i­dent Ni­co­las Maduro’s gov­ern­ment to buy time for it­self.

Maduro still holds power, but the U.S. and other govern­ments deem his rule il­le­git­i­mate. In­stead, the gov­ern­ment-in-ex­ile of Juan Guaido — the leader of the Na­tional Assem­bly — rep­re­sents Venezuela in U.S. courts and else­where. Con­cerned about the po­ten­tial loss of CITGO, Guaido and his team ap­proved a smaller pay­ment on the PDVSA 2020 bond in April this year.

But we doubt that Venezuela can af­ford the up­com­ing pay­ment. More im­por­tant, there also are doubts about whether the Venezue­lan peo­ple should be re­spon­si­ble for hon­or­ing a debt con­tract that their elected rep­re­sen­ta­tives did not ap­prove.

Most le­gal sys­tems rec­og­nize that not all con­tracts have the same de­gree of sanc­tity. For ex­am­ple, ac­cord­ing to ba­sic agency law in the U.S., a cred­i­tor can­not en­force a debt con­tract made through an agent of the cor­po­ra­tion whom the cred­i­tor knew was not au­tho­rized to con­duct such a trans­ac­tion. Given that the is­suance of the PDVSA 2020 bond was not au­tho­rized by the Na­tional Assem­bly, Venezuela might have le­gal de­fenses if cred­i­tors try to seize CITGO.

Other govern­ments have dis­puted cred­i­tors’ claims in sim­i­lar con­texts. No­tably, Puerto Rico has dis­puted debt is­sued in 2012 and 2014 that ar­guably vi­o­lated a con­sti­tu­tional debt limit. Sov­er­eign states such as Ukraine and Mozam­bique have re­cently made sim­i­lar ar­gu­ments, and there are a num­ber of older cases in­volv­ing mu­nic­i­pal debt.

These dis­putes raise ques­tions of both tech­ni­cal and the­o­ret­i­cal im­por­tance. As a tech­ni­cal mat­ter, a court would have to de­cide whether Venezue­lan law de­ter­mines the Maduro gov­ern­ment’s author­ity to is­sue the PDVSA 2020 bond, or whether that ques­tion will in­stead be gov­erned by New York law (which the bond des­ig­nates as gov­ern­ing most is­sues).

Even if Venezue­lan law de­ter­mines whether the Maduro gov­ern­ment was in fact au­tho­rized to in­cur this debt, New York law may gov­ern other im­por­tant is­sues, such as whether in­vestors were en­ti­tled to rely on the gov­ern­ment’s rep­re­sen­ta­tions about the bond’s le­gal­ity.

More broadly, dis­putes like this re­quire courts to de­cide whether cred­i­tors should bear the risk that unau­tho­rized debts can be re­pu­di­ated. At first glance, it may seem odd to im­pose such a risk on cred­i­tors.

Venezue­lan of­fi­cials, af­ter all, are in a good po­si­tion to un­der­stand and com­ply with their own coun­try’s le­gal re­quire­ments. If they say that the bond is­sue is le­git­i­mate, why should for­eign cred­i­tors doubt them?

But as Ri­cardo Haus­mann re­cently pointed out, this view ig­nores the agency prob­lems in­her­ent in gov­ern­ment debt: Pub­lic of­fi­cials are sup­posed to rep­re­sent the pop­u­lace, but are some­times mo­ti­vated by self-in­ter­est. The prob­lem is es­pe­cially acute with despotic govern­ments.

Although the in­ter­na­tional com­mu­nity still rec­og­nized Maduro’s gov­ern­ment at the time of the PDVSA bond is­sue, it had al­ready se­ri­ously ques­tioned that gov­ern­ment’s le­git­i­macy. Venezuela’s cred­i­tors in 2016 knew this, just as they knew that the Na­tional Assem­bly had not ap­proved the bond.

More­over, cred­i­tors are of­ten so­phis­ti­cated. Investment banks that un­der­write com­plex col­lat­er­al­ized bonds like the PDVSA 2020 are surely ca­pa­ble of mak­ing in­formed judg­ments about whether a loan com­plies with le­gal re­quire­ments. In that case, they should bear the con­se­quence of a fail­ure of due dili­gence.

These cred­i­tors, not the Venezue­lan peo­ple, were in a po­si­tion to block the trans­ac­tion, yet now or­di­nary Venezue­lans risk los­ing a cru­cial na­tional as­set. And in the fi­nal anal­y­sis, im­pos­ing some risk on care­less cred­i­tors may be the best way to en­sure that politi­cians honor the lim­its on their bor­row­ing author­ity.

Some may ar­gue that this ap­proach could harm re­tail in­vestors who bought bonds on the sec­ondary mar­ket in good faith. This is un­likely to be the case for the PDVSA 2020 bond, be­cause even re­tail in­vestors with lim­ited in­for­ma­tion should have been aware of the un­sa­vory na­ture of the is­su­ing regime.

In any case, this ob­jec­tion could be ad­dressed by es­tab­lish­ing a pub­lic registry of all out­stand­ing sov­er­eign and quasi-sov­er­eign bonds that were is­sued with le­gal or eth­i­cal in­fir­mi­ties.

How Venezuela’s lat­est debt drama plays out will start to be­come clearer in the com­ing weeks. In­stead of be­ing just an­other story of de­fault, the PDVSA 2020 bond may yet be­come a cau­tion­ary tale for cred­i­tors around the world.

Mark Wei­de­maier

Mitu Gu­lati

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