Bondholders and Venezuelan Democracy

On Oct. 28, $913 million in principal and interest will be due on a bond issued by Petróleos de Venezuela, the state-owned oil monopoly, known as PdVSA. The contract says the bond, which matures in 2020, is secured by a controlling stake in U.S. oil refiner Citgo. Venezuela’s expected failure to make the payment will trigger an immediate default.

In that case the 2020 bondholders, as the creditors are known, are expected to go after the shares of Houston-based Citgo that were put up as collateral when the contract was written. The shares are sitting in a vault in New York.

On Wednesday Citgo chairman Luisa Palacios called on the Trump administration to keep that from happening. But even without help from the White House, the bondholders may find it more difficult to collect than they expect-despite the powerful argument that contracts are sacrosanct. That’s because there are serious questions about whether the contract is valid.

Venezuela has lots of unpaid creditors. But only the 2020 bondholders have a contract backed by control of Citgo. The bonds were issued by the regime of dictator Nicolás Maduro when Venezuela was having trouble rolling over debt. A fat coupon of 8.5% didn’t attract sufficient risk capital, so Mr. Maduro collateralized the bonds with 50.1% of the shares of Citgo. The Russian oil company Rosneft lent money to PdVSA that was secured by the remaining 49.9% of Citgo. Analysts project that the Rosneft loan may be repaid by year-end.

U.S. sanctions on the Maduro regime prohibit U.S. persons from engaging in transactions with either PdVSA or Venezuela. But in July 2018, to ensure that the sanctions wouldn’t protect Mr. Maduro from his obligations to the 2020 bondholders, the U.S. Treasury’s Office of Foreign Assets Control issued General License 5. The license allows the 2020 bondholders to take possession of the Citgo shares in the event of a default as the contract stipulates.

Since then things have changed. Mr. Maduro’s 2018 re-election was widely held to be fraudulent and in January his first presidential term expired. Constitutionally, Juan Guaidó, who was the democratically elected president of the Venezuelan National Assembly, had to step into the role as interim chief executive.

The U.S. quickly recognized Mr. Guaidó, and his interim government took control of PdVSA’s assets in the U.S.-chiefly Citgo. Mr. Guaidó named an ad-hoc PdVSA board of directors, which U.S. courts have recognized. He also named an ad hoc Citgo board.

Retaining control of Citgo is important for Venezuelan democrats. Mr. Guaidó’s supporters fear that if the bondholders seize the company’s shares it will strengthen Mr. Maduro. The 2020 bondholders would collect not only for the missed payment later this month but for a payment of roughly the same size due October 2020.

Citgo isn’t in financial trouble and naturally the ad hoc board wants to stop the 2020 bondholders from coming after the company. To that end it argues that the general license carve-out ought to be lifted and the sanctions applied to all parties equally. “After the support that was given in order to save Citgo from Maduro, it seems to me contradictory that the same effort would not be made here to save Citgo from Maduro’s bondholders,” Ms. Palacios said Wednesday.

The Trump administration hasn’t said why it hasn’t lifted the GL5 and there can be little doubt that creditor groups are applying pressure. But the courts may provide a better long-term outcome for Citgo.

A compelling legal argument is that Mr. Maduro didn’t have the authority, under the constitution, to pledge the company as collateral. In an opinion column last week, academics Mitu Gulati, Ugo Panizza and Mark Weidemaier questioned the validity of the bond contract. Under U.S. law, they write, “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.” That would seem to describe the 2020 bonds since the National Assembly loudly warned that it didn’t approve the collateralized bond.

The Venezuelan Constitution requires that the Assembly “approve contracts of national interest,” note Messrs. Gulati, Panizza and Weidemaier. In the case of the 2020 bonds the approval wasn’t granted, raising the question about the sanctity of the contract. Given that the bond was not authorized by the National Assembly, Mr. Guaidó’s government “might have legal defenses if creditors try to seize CITGO,” the authors write. They could even proactively ask a court to invalidate the pledge of shares.

It would be preposterous to suggest that the creditors didn’t understand the anti-democratic nature of the Maduro regime even as they were lending to it. They ought to also have known that the National Assembly didn’t approve the issuance of the bond.

There was money to be made in dealing with Mr. Maduro. There was also risk, which creditors may now have to eat.

By: Mary Anastasia O'Grady