Delaying the inevitable: What’s preventing Venezuela’s default?
Investors have experienced a week-long whirlwind of information following Venezuela’s default. In the last week, Caracas has hosted debt restructuring negotiations, seen its sovereign debt rating downgraded to “selective default” and has accepted debt relief from Moscow. To navigate the tumult, investors are looking towards one unlikely place: the District Court of Delaware.
Where are we now?
After years of fiscal mismanagement, bondholders were received in Caracas’ White Palace with chocolate gift baskets and arguably little else. Investors who had agreed to attend the event, despite concerns over who would lead the negotiations, were tasked with coming up with a plan for restructuring the government’s debt. Chief Negotiator and Vice President Tareck El Aissami, who is currently under U.S. sanctions for corruption and drug trafficking accusations, reportedly left after 20 minutes. Attendees to the long-anticipated meeting walked away confused, at best.
What followed was a deluge of ratings downgrades, which was only stymied after Caracas announced it had made the principal payment on a separate coupon. It briefly forced rating agencies to recant and stop short of placing the country’s sovereign debt rating at default, instead placing it at selective default. In laymen’s terms, they indicated that the country had indeed decided to skip a payment on a specific bond but remained committed to honouring its overall debt.
By week’s end, Venezuela’s largest creditors attempted to reassure bondholders once again. Moscow rolled out a debt restructuring deal that will allow Venezuela to make ‘minimal’ payments for the next six years, increasing the regime’s dependence on Russian cash. The Chinese Foreign Ministry released a separate statement affirming the country was capable of handling its debt appropriately.
The country’s bond price recovered from the initial dip earlier that week. By midweek, there was very little movement despite the credit agencies’ downgrades. Surprisingly, bondholder confidence appeared to have rebounded just the same. Many who gave interviews or commented on the subject expressed confidence that the Venezuelan government would make good on its future payments. Their belief is well placed, with principal payments out of the way.
Caracas now only has to pay interest until 2018 – giving President Maduro modest breathing room for several months. Caracas will be able to use this time to shore up Chinese and Russian support and continue paying the accrued interest, at least until the next principal payment is due in February 2018.
Venezuela’s default still looms
Yes, Venezuela will still default. Standard & Poor’s, which was forced to backtrack from its initial default call following the bondholders meeting, gave the country a “one-in-two chance it would default again within the next three months”. Others seem more enthused about the prospects of the country continuing to service its debt past February, namely brokers and investment bankers with close ties to Caracas.
When evaluating many of these brokers’ predictions, it pays to listen to those who maintain a close relationship with Venezuela’s ruling elite. For years these insiders have correctly predicted Venezuela’s macroeconomic maneuvering and have left economists asking the same question every time the country misses their interest payments: why doesn’t Venezuela just default?
The most likely answer is not an obvious one. Unlike Argentina and Greece, Venezuelan assets are liable for seizure throughout the region. State-oil company PDVSA has offshore refineries and oil receivable. Chief among them is Citgo: the Houston-based refinery has already been placed as collateral for several bond issuances. One would think Citgo would be a veritable goldmine for distressed securities investors; however, Venezuela does enjoy some legal protection from vulture funds in the U.S. under the Foreign Sovereign Immunities Act (FSIA).
The reason that default is not yet on the table is because a substantial amount of Venezuelan debt is owned by Venezuelans themselves. Many close to the regime are in fact Venezuela’s own creditors. In essence, when the Venezuelan Government dishes out principal payments, they are paying many of the officials who have mismanaged the country’s macroeconomy for years.
The District Court of Delaware – why it will determine whether bondholders collect
If Venezuela’s default is a question of ‘when’ rather than ‘if’, bondholders are likely aware of the inherent risk and are actively preparing for D-day. Vulture funds have been actively stockpiling bonds since their price began to fluctuate around 30 cents on the dollar. The bondholder’s meeting in Caracas likewise united several investors who will seek to target similar assets. But before developing any strategy, a case in Delaware has to be settled.
Deliberating in Delaware’s District Court is Toronto-based miner Crystallex (OTCQB:CRYXF, TSE:KRY), which is currently attempting to force collection of a $1.4 billion award it won over the expropriation of the Las Cristinas gold mine in 2008. To that end, Crystallex has pursued an alter ego claim against PDVSA and the Venezuelan Government. In essence, it contends PDVSA is a corporate entity controlled by the Venezuelan Government without any legal separation.
Crystallex thus seeks to collect the $1.4 billion award against the Government by executing upon the assets of PDVSA, mainly through its Delaware-based subsidiaries: Citgo Holdings (5368Z) and PDV Holdings. If Crystallex succeeds, the court proceeding will likely establish the necessary precedence for future claimants to make the alter ego argument and collect on U.S.-based Venezuelan assets.
However, intertwined into PDVSA’s legal defence against Crystallex is the contention that even if the Canadian miner were successful in its court case, the only subsequent option it would have would be to sell the disputed asset. Under current U.S. sanctions, those sales would be prohibited.
Although sanctions are easier to overturn than legal precedents, the court’s ruling will affect every bondholder that currently plans to attempt to collect on Venezuelan debt through its oil assets. Investors should pay close attention to the case’s outcome – their portfolio might depend on it.
