Shrinking Pie: The ugly world for Venezuela's creditors.

• Author: Kargman, Steven T.

Major litigation risks facing both the Republic of Venezuela and its state-owned oil company PDVSA could considerably complicate and even potentially diminish the prospects for an orderly and successful restructuring.

The Venezuelan sovereign debt situation is unlike other recent prominent sovereign debt restructurings, since the sovereign debtor in question has assets outside of its own borders that could be subject to possible creditor attachment. As a practical matter, creditors in sovereign debt restructurings are often prevented from attaching many, if not most, of the properties of a sovereign outside the sovereign's own borders. Specifically, due to special immunities enjoyed by sovereigns, creditors cannot attach a sovereign's most obvious overseas property such as the sovereign's embassies and consulates. Moreover, as long as the sovereign is not engaged in what is considered "commercial activity" in the foreign jurisdiction, its overseas property is protected under the theory of so-called restrictive sovereign immunity (which is embodied, for example, in the U.S. Foreign Sovereign Immunities Act). But Venezuela has valuable assets outside of the country, including PDVSA's Citgo-related assets in the United States.

By contrast, during the sovereign debt restructuring following its 2001 default, the Republic of Argentina had few attachable assets outside the country. Despite the court judgments outstanding, holdout creditors then had limited options for collecting on their judgments given the scarcity of assets outside of Argentina that were not shielded by sovereign immunity. Except for certain hedge funds that pursued a long-running, aggressive, and costly litigation strategy, creditors were generally not able to collect on their judgments.

However, the existence of PDVSA assets and operations outside of Venezuela has already presented tempting targets for creditors of the Republic, particularly in view of the "alter ego" theory embraced by the U.S. Court of Appeals for the Third Circuit in the Crystallex litigation, which broadly allowed creditors who obtain judgments against the Republic to execute against the assets of PDVSA and/or its affiliates.

Normally, though, creditors of a sovereign cannot attach the assets of a state-owned entity to satisfy a judgment against the sovereign as long as the state-owned entity is operating as an independent, separate entity (that is, the state-owned entity has its own legal personality). Yet the "alter ego" theory allows creditors of the sovereign to essentially disregard the separate corporate form of the state-owned entity (such as PDVSA) and thus the assets of the state-owned entity become subject to attachment by the creditors of the sovereign.

(In late September 2019, the U.S. Court of Appeals for the Third Circuit lifted a judicial stay that had been put in place preventing Crystallex from executing on its judgment and seizing the shares of Citgo's holding company, giving Crystallex the green light to proceed with its enforcement efforts, subject to any court challenges or appeals that might arise in the interim.)

RACE TO THE COURTHOUSE

A protracted delay in initiating a debt restructuring process for Venezuela in circumstances where some creditors have already pursued litigation could encourage other creditors to consider initiating their own legal actions. In this pre-restructuring period, creditors may not wish to be left out in the cold if other creditors have already begun to pursue or ultimately realize recoveries on their claims. This dynamic has the potential to set off the classic--but often dreaded--"race to the courthouse."

Such a race is not conducive to any orderly restructuring process at a later date, and that is why a stay or moratorium on creditor actions against a debtor is considered an indispensable feature of any well-designed insolvency law. Moreover, a race to the courthouse runs counter to the crucial principle in insolvency law of equality of treatment for similarly situated creditors, since it privileges certain creditors--those bringing lawsuits and making recoveries--at the expense of others who do not bring lawsuits and achieve recoveries on their unpaid debt.

Furthermore, there is a significant related risk that such creditors carve up the debtor's assets before an orderly restructuring can take place. Such a prospect could give rise to what is referred to in the insolvency literature as the "premature dismemberment" of the corpus or pool of assets that would be used to support any eventual out-of-court restructuring or in-court formal reorganization.

Significantly, this "premature dismemberment" dynamic could result in fewer resources of the debtor being available to support any eventual restructuring, thereby...