By Maximilian Hess
In July, the Bear Market Blog examined how risks Moscow faced in the event of regime change and a subsequent default by Venezuela. This piece follows up by examining the strengths of Moscow’s position in a post-default restructuring with the Maduro regime still in place.
On 16 November, Venezuela was found to have formally defaulted on its debt. Venezuela had already been expected to be the most complex sovereign debt restructuring of all time, with various theories put forward as to how it can be best achieved given its inherent difficulty. These proposals skirt around the core issue, however: the first step in determining the viability of any proposition is to ask who benefits. Bondholders and the Venezuelan government have already begun discussions about restructuring despite the additional challenges posed by US sanctions on the Venezuelan regime and new debt issuances, as well as doubts over the Venezuelan regime’s stability amid hyperinflation. For any of these proposals to bear fruit they will have to pass one key litmus test: whether they can gain support from Russia and Rosneft.
The-PDVSA-is Venezuela and Venezuela-is-PDVSA restructuring.
Arguably the most prominent proposal is from Lee Buchheit, the “philosopher king of sovereign debt lawyers”, and his frequent collaborator Mitu Gulati, Duke University’s resident “Renaissance Man in Law”. Their proposal, formalized at the end of October, is to begin the process by recognizing that the distinction between debt issued by PDVSA (Venezuela’s state-owned oil and gas company) and debt issued by the Venezuelan sovereign should be consolidated.
Adam Lerrick of the American Enterprise Institute, another leading voice on sovereign debt issues, has put forward a similar proposal. Gulati points out their proposal differs from Lerrick’s on the question of what should happen to PDVSA’s oil assets, a key question for one major creditor in particular – Rosneft. Buchheit and Gulati “suggest that PDVSA pledge those assets to the Republic in consideration for the Republic’s assumption of PDVSA bond/promissory note liabilities (as opposed to transferring title to the assets back to the Republic). Such a pledge…should operate to shield the assets from attachment by holdout creditors”.
Effectively what Gulati and Buchheit are arguing is that this kind of transaction could make any holdout creditors unable to seize PDVSA assets, thus diminishing the incentive for non-consenting creditors. They cite the example of the restructuring that took place in post-invasion Iraq, where Baghdad was able to negotiate an 80% nominal write-off of its Paris Club debtUN Resolution 1483. Iraq ultimately settled with private creditors (roughly equivalent to Venezuela’s bondholders in this instance): creditors with claims under $35m received a cash buyback equal to 10.25% of what they were owed (including accrued interest), while others received new securities through a series of debt-for-debt swaps, though this debt immediately began trading at below par value.
Russia also played a role in the Iraqi restructuring, agreeing in 2008 to write off some 93% of the almost $13bln Baghdad owed it, restructuring the remaining $900m over 17 years. The deal reportedly included guarantees Russia’s largest private oil company, Lukoil, would be able to return to developing the West Qurna field, having initially won the concession in 1997 under then-President Saddam Hussein. Lukoil was awarded a contract to return to the field in 2009.
The circumstances in Venezuela are far more favorable for Russia than they were in Iraq’s restructuring although it is highly unlikely to be able to secure a similar UN Resolution, making Gulati and Buchheit’s suggestion less than directly comparable. Unlike Rosneft, Lukoil did not have the heft of being a sub-sovereign entity, and the US invasion of the country and backing for its nascent government gave Washington a substantial say over how events played out. In Venezuela, the situation is nearly reversed, with Rosneft and Moscow holding major levers over both the Venezuelan economy and its government.
Gulati and Buchheit highlight a potential problem in another recent paper. They note that the fallout from Argentina’s debt saga gave bond holdouts a new tool through pari passu clauses. Argentina’s 2014 default had a significant impact on the sovereign debt landscape as holdout bondholders impacted other creditors, not just the sovereign. Venezuelan sovereign bonds issued before 2003 may be of particular relevance given they require unanimous creditor agreement to restructure and include pari passu clauses. Bondholders and the Russian sovereign were on opposite sides in the fight over Ukraine’s 2015 restructuring and could again spar over these issues.
Gulati and Buchheit’s proposal faces another key issue, which is that Rosneft, to which PDVSA owes at least $6.5bln, already receives hundreds of thousands of barrels per day from PDVSA in lieu of cash repayments, although the exact terms of the arrangement are not known.
‘A la Ecuador’
Ecuador provides precedent for another potential ‘restructuring’. In December 2008, when President Rafael Correa repudiated $3.2bln in bonds issued by Ecuador, claiming they were issued illegally. Ecuador then bought back more than 90% of the defaulted debt on secondary markets, where it was trading at 35 cents on the dollar. The effect was to secure a 65% haircut in its sovereign bond obligations.
Were Venezuela to pursue a similar strategy, China or Russia, and most likely both, would have to spend to assume significant additional Venezuelan debts. Venezuela lacks the liquidity to purchase back the same share of its outstanding bonds itself due to the evaporation of its foreign currency reserves, compounded by US sanctions. Moscow and Beijing would likely have to step in and buy back Venezuela’s debt on secondary markets. Venezuela’s bonds already trade well below face value and domestic political turmoil could drive them down further. This could be an attractive option, if not for the risk of holdouts bearing Venezuela’s pre-2003 sovereign bonds.
Nevertheless, the 30 November arrests of two former PDVSA directors could in theory set the groundwork for Venezuela to argue that some of PDVSA’s debts were issued illegally under Venezuelan law. Yet markets so far indicate that bondholders view PDVSA notes as less risky than Venezuelan paper, as witnessed by reversal in the yield of Venezuelan sovereign bonds and PDVSA bonds. It is widely assumed it would be easier to secure judgements seizing PDVSA assets than it would be to do so by suing the sovereign. However, at least one prominent player from the Argentine bond dispute cautions against this, as does Lerrick, with a concern that under Venezuelan law, PDVSA’s assets could be signed over to another entity, casting doubt on the likelihood a suit would result in seizures. The 13 December credit default swap auction did value PDVSA debt below that of the sovereign, however, this is at least in part due to the inclusion of a particularly-controversial PDVSA note issued earlier this May.
The ‘a la-Ecuador’ model would likely only to come to pass if China and Russia would be willing to buy almost all of their existing bonds themselves or provide Venezuela with the funds to do so. The outstanding $65.5bln in Venezuela and PDVSA notes means that even if they were able to secure a discount along the lines of what Ecuador was able to achieve, this would cost around $23bln, although much Venezuelan debt already trades at larger discounts. But even one holdout on the aforementioned bonds issued before 2003 means an extensive dispute could still be in the offing; one that would risk leaving Moscow and Beijing in the awkward arguing that they did not, in fact, want to be paid in full, at least on the bonds.
Pawn the jewels
Another prominent restructuring proposal was put forth by Millstein & Co.’s Mark Walker and Cleary Gottlieb Steen & Hamilton’s Richard Cooper. They acknowledge that their proposal is unlikely to gain traction with the current government, barring a fundamental shift in its strategy given that it would likely require Caracas to sell off or mortgage many of the country’s natural resources, likely on sub-optimal terms.
This is highly unlikely to be smoothed over by a package from the IMF given that the regime expelled the fund in 2007 and continues to fail to meet its obligations to share information with the fund. Sanctions, the potential size of the bailout, the effective US veto, and the virulent opposition of the Maduro regime to adopt the liberalization prescribed by the IMF mean that such a rescue is only likely in the event of a regime change.
Walker and Cooper note that “with some $37 billion or more of outstanding debt to China/CDB and Rosneft/Russia alone, it is likely that bondholders will want to see some reasonable alignment of payment to both groups”. The authors then warn that “Russia and China themselves may argue to the contrary on the grounds that funds supplied by them have been used, at least in part, to keep bondholders current”. In their proposal, they also call for steps to be taken to protect Citgo, the US-based energy company that is a PDVSA subsidiary, again noting that an agreement here would either require a US Chapter 11 bankruptcy filing or reaching a standstill agreement with bondholders – who hold security over the company’s shares – and Rosneft, which holds security over 49% of Citgo shares. This security has been heavily criticized by US officials and politicians, of which bondholders will be keenly aware.
There is already evidence that Rosneft is taking action to prevent the seizure of PDVSA’s assets in the event of a lawsuit and to alleviate the risks it could be pre-empted by US legislation regarding Citgo. More asset dissipation may already be taking place. On 17 December Rosneft announced it would take over two gas fields from PDVSA. While the terms were not specified the language of the Venezuelan government’s announcement indicates the licenses may have been granted in relation to previous loans. Although he has since been arrested by Venezuelan authorities, then-oil minister Eulogio Del Pino acknowledged such discussions in comments in a Moscow forum on 4 October. Russia is likely to seek formal title or at least security over a number of Venezuelan oil fields.
These reports indicate that Caracas is at least willing to part with some of its jewels in exchange for political stability. President Nicolas Maduro already publicly offered up oil, gold and diamond assets to back a much-maligned ‘cryptocurrency’, which is unlikely to gain traction. Such assets will also be alluring to holders of Venezuela’s debt. The fact Rosneft has apparently beaten other debtholders to the negotiating table, as well as its Citgo collateral, means that Russia will have to have a seat at the table from the initial stages of the restructuring.
Much has been written about the use of Rosneft as a foreign policy tool in recent years and its relative successes and failures. In this instance, it has managed to make itself central to any potential Venezuelan restructuring under the current regime. Bondholders face hurdles in the sanctions on Caracas, those on Rosneft’s CEO Igor Sechin, and the fact they will be in a weak position, at least politically, against Rosneft’s claims. Rosneft’s actions also serve to align Moscow and Beijing’s interests with regards to Venezuela, as Beijing’s own investments into Venezuela should be seen as being geoeconomically motivated, rather than profit-driven. As long as the Maduro regime remains in power, Rosneft’s actions have in this instance served Russian foreign policy interests well.