The lives of Puerto Rico residents remain profoundly disrupted by the aftermath of Hurricane Maria measured by metrics such as electricity, clean water, health care access, with death tolls mounting. This week, though, in a federal court hearing on January 10, 2018, Puerto Rico has the extra burden of confronting Hurricane Aurelius.
Aurelius Capital Management seeks to invalidate a key element of PROMESA, the 2016 law that, among other things, created a bankruptcy process for the Puerto Rico that has been underway since May 2017, managed by an Oversight Board that has been working through its PROMESA tasks for many months longer. (For those looking for PROMESA, it is codified as Chapter 20 of Title 48 of the U.S. Code). Specifically, Aurelius challenges the Oversight Board selection process as violating the Appointments Clause of Article II of the U.S. Constitution. Defenders of the law's constitutionality, including the Trump Administration, say the Appointments Clause does not apply to the Oversight Board for a host of reasons.
Bipartisanism doesn’t guarantee that any law is constitutional, of course. But this dispute stings a bit more because PROMESA was perhaps the most collaborative and bipartisan pieces of legislation in the last Congress, if not the last two or three, and the Oversight Board selection process, per PROMESA's requirements, was consultative. Among bondholders and insurers, Aurelius is almost certainly not alone in wishing the restructuring was going differently and that the current Oversight Board were more in their corner. But other financial creditors may be too chastened by the ongoing devastation facing the residents of Puerto Rico from Hurricane Maria to use a major constitutional battle in the hopes of collecting a few more cents on the dollar under such circumstances. Or by the relatively thin state of Appointments Clause scholarship and that the pieces that must come together to establish an Appointment Clause violation here remain an uphill battle.* Not Aurelius. It persists in pushing for the ultimate do-over. The track record of this hedge fund, including what was recently reported in a recent federal bankruptcy court decision in Oi Brasil Holdings,** speaks for itself.
The relief sought in the Puerto Rico Appointments Clause litigation is outright dismissal of Puerto Rico's bankruptcy (along with the automatic stay on collection) on the basis that all of the Oversight Board's acts to date are void ab initio. A new Oversight Board would have to be appointed with advice and consent (how long that would take in today's Washington D.C. is anyone's guess). Perhaps Aurelius is rolling the dice that, if it prevails, President Trump would appoint to the Oversight Board people willing to keep Puerto Rico out of bankruptcy. That won't make Puerto Rico any richer. It just allows for an Argentina-style situation in which a deep-pocketed party can press hard for a higher return to keep all for itself, whatever the consequences for everyone else.
*Blocher and Gulati have raised concerns about the role of the Insular cases in this dispute. I don't see those cases as integral to PROMESA's constitutionality.
**As Drew Dawson pointed out in comments on an earlier Gulati post, the lengthy and detailed court decision carefully outlines Aurelius' strategy in a transnational insolvency.
Mark Weidemaier & Mitu Gulati
Ricardo Hausmann, Harvard economist and former Venezuelan Planning Minister, has been a thorn in the side of the Maduro administration. His blog posts at Project Syndicate condemning the Maduro administration’s continued payment of bondholders while the people of Venezuela starve may well have deterred new lending to the regime. Among other things, Hausmann-induced opprobrium at Goldman Sachs’s infamous "hunger bond"—now trading at a deep discount--has scared many in the market. For more background, check out Cardiff Garcia’s FT podcast interview with Hausmann.
Hausmann’s latest Project Syndicate post goes well beyond complaining about the ethics of Wall Street bond investors. Hausmann first sets out his view of the political realities, in which Maduro’s manipulation of elections and co-option of the military negate any realistic chance for the political opposition to overthrow the regime, notwithstanding U.S. economic sanctions. Given the severe humanitarian crisis, astonishing depletion of national wealth, rampant inflation, widespread corruption, and other harms inflicted or exacerbated by the Maduro regime, Hausmann advocates military action by the United States and like-minded nations. The other nations presumably include countries like Peru, Columbia, Honduras, Argentina, and Chile, all signatories to the Lima declaration condemning the Maduro regime.To quote Hausmann:
As solutions go, why not consider the following one: the National Assembly could impeach Maduro . . . [T]he Assembly could constitutionally appoint a new government, which in turn could request military assistance from a coalition of the willing, including Latin American, North American, and European countries. This force would free Venezuela, in the same way Canadians, Australians, Brits, and Americans liberated Europe in 1944-1945. Closer to home, it would be akin to the US liberating Panama from the oppression of Manuel Noriega, ushering in democracy and the fastest economic growth in Latin America.
Whoa! Article 2(4) of the United Nations Charter prohibits states from using force against the territorial integrity or political independence of other states. It is generally thought that there are only two exceptions to this ban: cases involving Security Council authorization (presumably because of conditions such as genocide) and self-defense. This was, of course, not the case before World War II, when Western nations often intervened militarily in the affairs of other nations. The threat of military intervention was implicit, and at times explicit, in doctrines articulated by U.S. presidents concerning the relationship between the United States and Latin America. But these faux legal-sounding doctrines, such as the Monroe Doctrine and the Roosevelt Corollary, are not part of international law.
Hausmann, presumably, is well aware of these doctrines and regards them with disdain. He seemingly wants to expand—dramatically, in our view—the narrow exception for humanitarian intervention where there has been no Security Council authorizing resolution. Let’s call this the Hausmann Addendum. There is some recent precedent; the U.S. bombed Syria without prior Security Council approval in response to the use of chemical weapons. But it is hard to apply that precedent here. For one thing, it isn’t clear the U.S. acted lawfully. If not, the U.S. cannot unilaterally create an exception to international law by acting contrary to it; exceptions come into being only when a new practice becomes widely accepted. For another thing, the failure to secure Security Council approval in advance conceivably might have been justified by the Assad administration’s clear violation of international law and by the need for an urgent response. It isn’t clear that both conditions obtain in Venezuela.
To justify intervention, Hausmann suggests that the opposition-controlled National Assembly of Venezuela could invite foreign armed intervention. Indeed, some legal advisers see an exception from Article 2(4)’s prohibition on the use of force in cases involving the host government’s consent. But is an invitation from the opposition enough? Much as we admire Hausmann, and share his distaste for the despotic current government, we think it very hard to justify the legality of his proposal.
Here's John Bellinger, former State Department and National Security Council legal adviser (2001-2009) at Lawfare on the Syria action:
Under the U.N. Charter, the U.S. is prohibited from using force in Syria unless authorized by the Security Council or exercising its right to individual or collective self-defense. The U.S. Government—like most other governments (with the exception of the United Kingdom and Denmark)—has never recognized a right of humanitarian intervention under international law.
This doesn’t mean that international law could not or should not allow more scope for humanitarian intervention. Anyone paying even minimal attention to the genocide of the Rohingya in Myanmar must be frustrated by the international community’s unwillingness to do much of anything about the horrors there. Bellinger quotes Nikki Haley as saying (in the Syria context): “When the United Nations consistently fails in its duty to act collectively, there are times in the life of states that we are compelled to take our own action.” But, to reiterate, if the intervention in response to the use of chemical weapons on civilians in Syria was a stretch, it is a giant leap to justify armed intervention in Venezuela. For those interested in more, there are interesting discussions on this topic by Milena Sterio and Ryan Goodman, here and here.
Hausmann knows better than we do the fraught and ugly history of foreign (and particularly U.S.) intervention in Latin America. So it is not surprising that even the Maduro administration’s critics were surprised by his proposal. Here’s Bloomberg, and Reuters, reporting opposition to the notion of U.S. intervention, recalling President Trump’s suggestion in August that military intervention might be in the cards. (Trump didn’t bother to ground his threats in international law.) And over at Caracas Chronicles, José González Vargas reminds that it doesn’t always end well to initiate a “long, slow bloodbath of a guerrilla war in an oil country shaped by decades of authoritarian military government.”
And then there is the fact of utter chaos in the current administration in Washington DC. We are more than a teensy bit skeptical that the, ahem, organs of the U.S. executive branch can formulate and execute coherent foreign policy. It is frankly hard to fathom a Trump-led international coalition that both overthrows the Venezuelan government and leaves something other than chaos in its wake. Without question, Maduro has unflinchingly presided over a humanitarian disaster for Venezuelans. But the fundamental question, even putting aside international law constraints, is whether the U.S. can take steps to benefit the Venezuelan people that are both politically feasible and unlikely to spawn the dire collateral consequences that might follow military intervention.
Perhaps we are blinkered by our perspective on sovereign debt. But it seems to us that the U.S. can do the most good and the least harm by taking steps to ensure that a legitimate Venezuelan government has access to an orderly, deep debt restructuring. The current US administration, for all of its flaws, has taken halting steps in that direction. And there is more it can usefully do. For both Venezuela and PDVSA, the most crucial restructuring-related activity will take place in U.S. financial markets and in U.S. courts. The U.S. government can play a role here—options include shielding oil operations in the U.S. from creditor enforcement (as Anna Gelpern has noted) and appearing in court to limit the ability of holdouts to impede a restructuring. Examples of the latter might include supporting the validity of a Venezuelan bankruptcy law enacted for PDVSA. Politically, none of these are easy to justify, but if conditioned on regime change, they might pass muster. As for regime change itself, we hope it comes soon. But we’re also skeptical that the current administration in the U.S. can play a productive role in making it happen.
Mark Weidemaier & Mitu Gulati
On Wednesday, the Third Circuit granted Venezuela a victory in its ongoing settled-but-not-settled litigation with Crystallex. The case deals with a limited issue: Whether Delaware law imposes liability for the fraudulent transfer of an asset on an entity that is not itself a debtor. We want to use this post to speculate a bit about the implications the decision may have for the bigger Venezuelan debt drama. If the new decision is important, it is because it signals something about the receptivity of US courts toward claims that Venezuela, PDVSA, and perhaps US entities like CITGO are “alter egos.” We disagree a bit about that question. But first, some background on this aspect of the Crystallex case.Crystallex holds a judgment against Venezuela for over $1 billion and has been looking for ways to collect. The case is in an odd limbo, in that there has been a settlement, which Venezuela does not appear to be paying. (Perhaps it’s sending Crystallex chocolates.) Plus, the settlement calls for payment in installments, and Venezuela may stop paying even if it pays now. In any event, many of Crystallex’s legal theories can be replicated by other creditors, especially the claim that PDVSA is Venezuela’s alter ego. If successful, that claim would allow Crystallex to seize PDVSA’s assets (if not protected by sovereign immunity). In the U.S., those assets consist of shares in PDV Holding, the ultimate parent company of CITGO Petroleum.
Before the settlement-not-a-settlement, Venezuela proclaimed that it had no intention to pay Crystallex and similar creditors with judgments against the government. Because it’s a sovereign government, Venezuela’s assets are protected (but not absolutely) by sovereign immunity. Its assets are also protected by the corporate form, because assets held by state-controlled entities like PDVSA, and ultimately CITGO, belong to those entities, not to the government itself. If a creditor succeeds on an alter ego theory, these legal barriers between entities dissolve.
In any event, Venezuela was concerned that its creditors, or creditors of PDVSA, would go after CITGO. So it decided to extract as much wealth from CITGO as possible. According to Crystallex (though few dispute this), Venezuela did this by causing CITGO to issue $2.8 billion in bonds and then to pay the proceeds out as a dividend.
The Third Circuit’s decision deals only with PDVH’s liability to Crystallex under Delaware law. Upset that Venezuela had siphoned wealth from CITGO, Crystallex alleged that the dividend payment was a fraudulent transfer under Delaware law. In a purely formal sense, of course, the transfer was almost exactly the opposite of a typical fraudulent transfer, in that it involved a transfer of assets to the debtor from a non-debtor. But of course, the practical effect was to stiff the government’s creditors. That’s because they have no practical ability to recover money held by Venezuela. Their only realistic hope is to seize assets held by other entities in the U.S. And that, again, requires them to prove that these entities are Venezuela’s alter egos or otherwise liable for its debts.
Although the district judge had ruled in Crystallex’s favor, the Third Circuit, by a 2 to 1 vote, reversed. The majority held that a non-debtor can’t be liable for a fraudulent transfer under Delaware law. PDV Holding is a non-debtor precisely because no court has found it to be Venezuela’s alter ego; in fact, Crystallex didn’t allege (much less prove) the contrary. The dissent would have affirmed the district court, on the theory that a non-debtor’s transfer of property at the direction of a debtor (Venezuela) violated Delaware law.
What does all this mean for future alter ego or veil piercing cases? Here, we disagree a bit. In a nutshell, Mitu wonders if the Third Circuit decision might be a signal that veil piercing claims face a tough uphill climb under Delaware law. Delaware, as the court points out in its decision, is a jurisdiction that takes corporate formalities seriously. And certainly Venezuela’s conduct was shady here; all judges seem to acknowledge that it essentially directed these transfers. If that isn’t enough to impute liability to a legally-separate entity, future litigants will need to come up with something even stronger. He agrees (with Mark!) that veil piercing and similar theories should work differently in the sovereign context.
Mark thinks that's just nuts. No, actually he shares the view that creditors will have a hard time convincing courts to disregard the separate legal status of the U.S. entities (though an easier time with respect to PDVSA). But he doesn’t read very much into the Third Circuit’s decision. Without credible alter ego allegations against PDVH, the Third Circuit would have to expansively interpret Delaware fraudulent transfer law, which plays a key role in all kinds of cases, usually not involving sovereign governments.
In any event, it is odd that a case that has ostensibly been settled continues to produce new law and to be actively litigated. Which brings us back to a question that we and others have asked before: What exactly is the point of this settlement?
Poland has been thumbing its nose at key European Union norms for some time now (refusal to comply with environmental commitments, unwillingness to take refugees, and so on). The most recent and egregious norm violation being the reforms of the judiciary being pushed by the current right-wing ruling party that will (in the view of critics) enable it to stack the judiciary with judges favoring it. These were signed into law by President Duda roughly ten days ago.
The European Commission, the EU’s principal administrative body, viewing these latest actions as inconsistent with basic democratic commitments of all EU nations to rule of law principles (independence of the judiciary and so on), has recommended that Article 7 proceedings be initiated. That could end up stripping Poland of its voting rights in EU matters; something that would be unprecedented in EU history. As a practical matter this is not likely to happen, because the removal of voting rights requires a unanimous vote of the remaining 27 members of the EU, and Hungary (with a government of similar inclinations to the Polish one) is one the members. But in a community that values collegiality and cooperation to a very high degree, this is a big deal (at least to this outsider).
There is a broader question here, that some in the press are already asking, which is whether, at some point soon, Poland’s (and perhaps Hungary’s) refusals to act consistently with EU values can constitute enough of a justification for the rest of the EU to expel them? As I explain below, an argument can be made that no member of the EU can ever be expelled, given that there is no explicit process contemplated in any of the EU treaties for expulsion. But can that really be the case?
This question of expulsion from the EU has come up before; specifically, with respect to Greece in 2011-2014 when Greece was viewed by many of its fellow Euro area members as having dragged the entire Euro area into a deep crisis thanks to a combination of fiscal mismanagement and unwillingness to embrace the necessary austerity measures. During the crisis, because of the widespread resentment in some corners of the Euro area to providing financial assistance to Greece, there were numerous calls for Greece to be given the boot (more polite versions of the argument suggested that Greece take a temporary “vacation” from its membership of the union). So, the question was posed: Can fiscal irresponsibility and an unsustainable debt stock (okay, plus a little fudging of the accounting numbers) can justify expulsion?
Some took the strong view that expulsion from the EU was simply not allowed (see here, here and here). Once one was in, exit could only occur voluntarily; Brexit, being a case of voluntary exit. The legal rationale being that the treaty does not describe a procedure for expulsion, and that must therefore mean that expulsion is off the table. To me, that’s a teensy bit too formalist for my liking. There are often good reasons to avoid putting in clauses about expulsion or ejection in a contract, even if everyone involves knows that it might need to occur. Some things are just too hard to talk about – especially during euphoric times when all the parties involved are trying to show each other how much they trust and love one another. The question surely is: What are the implied terms?
Jens Damann has a super piece on this, and disagrees with the formalist view articulated above. Joseph Blocher, Larry Helfer and I come to roughly the same conclusion as Jens, albeit via a somewhat different route. None of us thought, at the time, that Greece’s debt crisis justified expulsion. But the questions raised by the Greek situation got us arguing hypotheticals (the most fun of these were over bourbon at the Washington Duke). And the question we inevitably ended up with was: Surely, at some point, a country could behave in a manner so very inconsistent with the basic commitments of the union that expulsion could be said to be justified by the implicit terms of the joint enterprise? Poland looks to be testing those boundaries - For example, let us say some hypothetical EU country decides that it wants to summarily curtail the rights of all non-white citizens in obvious violation of the basic human rights commitments of all EU members. Could the rest of the EU not decide that this action was a bridge too far, and decide to vote to expel this country?
Mitu Gulati and Mark Weidemaier
Over at Bloomberg, Katia Porzecanski notes that investors in Venezuelan debt are “worried they’re getting ghosted.” Overdue coupons are piling up, and no one is sure whether it is because the government is done paying or because U.S. sanctions have made financial intermediaries slow to process payments. Meanwhile, the government has maintained radio silence about the restructuring it purported to announce six weeks ago. The fact that a few PDVSA coupons have been paid in the meantime prompts Porzecanski to ask whether Venezuela is capitalizing on bondholder inertia to “quietly, selectively default,” and whether the government “may ultimately prioritize PDVSA’s debt over its own.” This Reuters article by Dion Rabouin answers the latter question in he affirmative, opining that Venezuela is more likely to default on its own bonds than on PDVSA’s, for two related reasons. First, PDVSA’s oil revenues are the government’s main source of foreign currency; second, a PDVSA default may prompt creditors to seize oil-related assets abroad, potentially including CITGO.Venezuela and PDVSA are massively indebted. Bond debt alone amounts to roughly $60 billion. Functionally, it makes sense to view this all as one giant debt pile, given the close relationship between the government and PDVSA and the latter’s importance to the country’s balance sheet. Formally, however, the two issuers are distinct (at least until they are ruled to be alter egos), with distinct legal status, distinct protections under the law of foreign sovereign immunity, and distinct restructuring options. Moreover, the outstanding bonds have different legal terms, both across issuers (e.g., most Venezuelan bonds have CACs; PDVSA’s do not) and within a given issuer’s debt stock (e.g., different government bonds have different CAC voting thresholds).
An issuer with a large debt stock must choose where to focus its efforts to get debt relief. One possibility is to impose greater losses on bonds with fewer legal protections, because investors in these bonds cannot put up a tough fight. Of course, other factors also matter. All else equal, for example, governments would prefer not to leave investors feeling as if they were treated arbitrarily. Still, investors who bought instruments with weak protections should suffer the biggest haircuts.
As it turns out, it’s not so easy to tell which bonds have weaker legal protections. On their face, the Republic’s bonds look easier to restructure because most have CACs, which allow for supermajority modification of payment terms. PDVSA’s bonds, by contrast, require each individual bondholder to assent to any such modification. This difference is one reason why the Reuters article linked above takes the view that PDVSA’s bonds are safer. But we are less confident in the importance of the CAC/no CAC distinction. PDVSA’s bonds may lack CACs, but other clauses can facilitate restructuring, including through the use of exit consents and by creating new liens consistent with the bonds’ negative pledge clauses. Moreover, PDVSA might be able to restructure in a Venezuelan bankruptcy proceeding, if the government passes bankruptcy legislation that merits recognition in the United States. To quote a prior article by Katia Porzecanski, quoting Jay Newman, formerly of Elliott:
The $30 billion of debt issued by PDVSA, in fact, may be worthless in a default, he says. “PDVSA doesn’t own the oil. It’s some amalgamation of production assets, trucks, offices and rusted pipe,” Newman said from New York. “The oil belongs to the state. If PDVSA is reorganized under local law, external bonds could be a zero. Investors should be thinking about the possibility that they will never see much, if anything at all, on their PDVSA bonds.”
Bond market prices seem to reflect this confusion. Last we looked, short duration PDVSA bonds seemed to be trading at higher yields that comparable Venezuelan bonds, but this relationship inverted for bonds with longer maturities. And the Republic’s recent behavior, which suggests it may favor payments on PDVSA bonds at least for now, complicates matters further still.
All in all, then, it may be a mistake to assume that the absence of CACs, and the need to protect oil-related assets from creditors, make PDVSA’s bonds the safer bet. As Anna Gelpern noted here previously: “I am struggling to see how the unanimity requirement or the pari passu clause in Venezuela 2027s and similar CAC-less bonds could save me from the howling monkeys.”
Key takeaways for Slips readers from a Moody's report, dated today:
The legislation is credit negative to the US sovereign, owing to the reality that the cuts do not pay for themselves, and Moody's estimates the cuts will add $1.5 trillion to the national deficit over ten years. Higher deficits will put further pressure on the federal government's finances, which are already facing prospects of increased costs of entitlements. Unless fiscal policy reverses course, Moody's estimates that the federal government's debt-to-GDP ratio will rise by over 25 percentage points over the next decade, to above 100%. Combined with rising interest rates, debt affordability for the US will weaken significantly.
The net impact to state and local governments is negative. While the new $10,000 limit on state and local tax (SALT) deductions does not directly impact state or local tax receipts, it will blunt the effect of lower federal rates for many taxpayers. Because the state and local provisions raise the effective tax cost for many taxpayers, public resistance to tax increases will likely rise, and that in turn will constrain local governments' future revenue flexibility. In addition, if larger federal deficits caused by the tax cuts result in attempts to cut entitlement spending, states will be pressured to backfill cuts to federal funds from their own budgets.
The SALT change, combined with the higher standard deduction and tighter limit on the mortgage interest deduction, also reduces the tax incentive for home ownership, which is likely to slow home construction and sales, and moderately suppress home values and property tax growth in higher-price markets.
I thought Credit Slips readers might be interested in using some holiday down-time to catch up on a couple of recent comparative insolvency conferences with particularly cutting-edge presentations, some of which are or will be available for viewing online (and many of the papers are available on SSRN or elsewhere).
First, on Nov. 23-24, the Notary College of Madrid offered its spectacular hall to host an international conference on consumer credit information privacy and regulation (day one) and the treatment of insolvency for SMEs and consumers (day two). The second day offered a particularly interesting presentation by one of the leaders of the EU Commission's initiative for a Directive on harmonization of European laws on preventive restructuring and second chance discharge relief (followed by a bit of constructively critical commentary by an American who fancies he knows something about European personal insolvency). Recordings of the entire conference were just posted to YouTube--most of the recordings are in Spanish, but the EU Directive and critical commentary presentations are in English after a short Spanish intro (nos. 8 and 9 of the 10 recordings). Congratulations to the architects of this fabulous event, who also made impressive presentations: Matilde Cuena Casas (Univ. Complutense de Madrid), Ignacio Tirado Martí (Univ. Autónoma de Madrid), and David Ramos Muñoz (Univ. Carlos III de Madrid).
Second, the following week offered a special, rare treat with the conference, Comparative and Cross-Border Issues in Bankruptcy and Insolvency Law, hosted by the Law Review of the Chicago-Kent College of Law. The line-up of panels on both comparative and cross-border issues was particularly impressive, and we were treated to a keynote by Jay Westbrook refining his latest thinking about cross-border coordination. The conference was live streamed, and the recordings are promised in the near future, but for now, the livestream page still has (scroll down to Day 1) the recoding of Adrian Walters's terrific paper on restrictive English interpretation of the notion of international cooperation. Again congratulations to the organizers of this fabulous event (who, again, gave very impressive presentations of their own): Adrian Walters, Chicago-Kent College of Law, and Christoph Henkel, Mississippi College School of Law.