The choice-of-law provisions in public debt notes: The case of the PDVSA 2020 Notes

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The State of New York Court of Appeals, on February 20, 2024, certified the United States Court of Appeals for the Second Circuit questions regarding the choice-of-law provisions in the case of the PDVSA 2020 Notes. The ruling confirmed that, despite those provisions, the Venezuela Constitution governs the capacity of the national oil company, PDVSA, to execute the indenture and pledge agreements.

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This judgment is a relevant decision that clarifies the interaction between New York Law and the Constitutional Law of the issuer, avoiding an interpretation that precludes the application of Constitutional Law, particularly regarding the checks and balances controls over public debt.

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II

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In October 2016, PDVSA executed the indenture of the 2020 Notes, issued with the collateral over 50.1% of the shares of Citgo Holding, Inc. As the State of New York Court of Appeals recalled, the indenture contains a New York choice-of-law provision, according to which “the notes shall be construed in accordance with, and this Indenture and the notes and all matters arising out of or relating in any way whatsoever to this Indenture and the notes (whether in contract, tort, or otherwise) shall be governed by, the laws of the State of New York…”.

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However, in 2019, PDVSA and Citgo Holding′s parent company, PDV Holding, Inc., filed a claim before the District Court for the Southern District of New York, arguing that the indenture and pledge agreement were null and void because PDVSA violated the Resolution approved by the National Assembly on September 27, 2016. The Resolution decided that PDVSA did not have the capacity to pledge the shares of Citgo Holding without the prior authorization of the National Assembly, by articles 150 and 187.9 of the 1999 Venezuela Constitution.

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It should be clarified that the Resolution was passed before the indenture and pledge agreement were executed. However, the Government of Venezuela ignored the parliamentary control exerted by the National Assembly, partly based on several rulings of the Constitutional Chamber that prevented the exercise of the legislative function by the National Assembly. Therefore, on October 28, 2016, PDVSA executed the agreements, ignoring the Resolution of the National Assembly.

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The District Court for the Southern District of New York dismissed the claim on October 16, 2020, concluding that, because of the choice-of-law provisions, the Venezuelan Constitution was not applicable, and as a result, the validity of the Notes could not have been impaired by articles 150 and 187.9 of the 1999 Venezuela Constitution.

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?PDVSA and PDV Holding appealed, and on October 13, 2022, the United States Court of Appeals for the Second Circuit decided to certify questions concerning the choice-of-law provisions.

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III

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The United States Court of Appeals for the Second Circuit observed that "this case raises important questions about the scope of an as-of-yet uninterpreted provision of the New York Uniform Commercial Code". There was no discussion about the New York choice-of-law clauses. The doubt was if, regardless of those clauses, the Venezuelan Constitution governs the contractual capacity of PDVSA as a state-owned enterprise. The Venezuela Constitution- observes the Court- "requires the National Assembly to approve contracts of national public interest". The Uniform Commercial Code "appears to call for the application of Venezuelan law to determine the validity of the 2020 Notes". Section 8-110(a)(1) provides that "the local law of the issuer's jurisdictions …governs…the validity of a security".

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The Second Circuit understood the implications of its decision, even beyond the 2020 Notes case. The choice-of-law issues “strike us as of utmost importance to the State of New York given its standing as the world’s preeminent commercial and financial center”. Hence, the Second Circuit decided to certify three questions to the New York Court of Appeals to clarify the interpretation of the choice-of-law clauses and the Uniform Commercial Code.

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IV

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The New York Court of Appeals answered that the “Venezuelan law governs the validity of the notes under Uniform Commercial Code § 8-110 (a) (1), which encompasses within its scope plaintiffs’ arguments concerning whether the issuance of the notes was duly authorized by the Venezuelan National Assembly under the Venezuelan Constitution”.

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Venezuelan Law applies only to the validity of the securities issued by a Venezuelan entity and "not as to other actions arising from or related to the transaction." Therefore, the effect of the invalidity under Venezuelan Law is nonetheless governed by New York law. In that sense, article 150 and its related provisions of the Venezuelan Constitution "determine the validity of securities issued by Venezuelan entities in this transaction”.

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The New York Court of Appeals did not decide on the merits of the claims. The question remains "whether, under those constitutional provisions, failure to receive authorization from the National Assembly before issuing the 2020 Notes means that the notes were invalid under the law of Venezuela at the time of their issuance".

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V

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Based on this ruling, the United States Court of Appeals for the Second Circuit should decide the pending appeal. As anticipated by the Second Circuit, “if the court concludes Venezuelan law applies to the particular issue of PDVSA’s legal authority to execute the Exchange Offer, then we would likely remand for an assessment of Venezuelan law on that question and, if necessary, for consideration of the Creditors’ equitable and warranty claims”.

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Consequently, the most probable scenario is that the case will be remanded to the District Court for the Southern District of New York to decide the claim filed by PDVSA and PDV Holding but considering the Venezuelan Constitution and the Resolutions issued by the National Assembly.

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VI

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The invalidity claim was based on the Venezuelan Constitution and its traditional interpretation at the time of the issuance of the 2020 Notes, according to which the national interest contracts executed by PDVSA with foreign firms must be previously authorized by the National Assembly, under articles 150 and 187.9 of the Constitution.

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According to the Venezuelan Constitutional Law, there is no doubt that the national interest contract signed by PDVSA with foreign firms must be previously approved by the National Assembly, even regarding the issuance of notes. That was the conclusion adopted by the Resolution of the National Assembly dated September 27, 2016. Based on the article mentioned above, 187.9 of the Constitution, the National Assembly denied PDVSA the capacity to pledge 50.1% of the shares of Citgo Holding to foreign firms because that pledge is a national interest contract.

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The Southern District of New York wrongly concluded that the September 27, 2016, Resolution did not declare the indenture null. Nevertheless, the National Assembly could hardly declare that invalid because, as of September 27, no agreement could have been declared null. The indenture and pledge agreement were executed after the Resolution, on October 28. What was relevant is that, before the Notes issuance and based on the Constitutional Law in force at that time, the National Assembly concluded that PDVSA could not pledge Citgo′s shares, invoking article 187.9 of the Constitution.

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In any case, the same National Assembly provided an authentic interpretation of the September Resolution. On October 15, 2019, the National Assembly approved a new Resolution that ratified that in 2016, the Assembly denied authorization to PDVSA to pledge the Citgo shares based on the constitutional framework applicable to the national interest contract.

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Therefore, the invalidity claim was not intended to evade PDVSA's obligation on an ex-post facto argument. Before the indenture and pledge were executed, the National Assembly, based on the 1999 Constitution, warned that PDVSA did not have the authority to pledge Citgo's shares, considering the long tradition regarding the prior controls over PDVSA's national interest contracts.

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VII

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The State of New York Court of Appeals judgment is a landmark decision that clarifies that the relationship between the New York choice-of-law provisions and the constitutional framework of the issuer is not one of rivalry but of complementarity. The choice-of-law clause applies to the issuer's obligations regarding the notes. However, New York law cannot regulate the issuer's capacity to issue notes, particularly regarding constitutional provisions applicable to SOEs.

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Otherwise, the Government could easily avoid constitutional provisions by accepting foreign choice-of-law clauses. However, PDVSA, as an SOE, cannot decide to avoid the application of the Constitution, including the regulations applicable to national public interest contracts and the binding Resolutions passed by the National Assembly. When PDVSA agreed on the New York choice-of-law provisions, it could not have decided to escape from constitutional mandatory and public policy provisions aimed at ensuring checks and balances.

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In that sense, a relevant aspect to be considered is whether investors should have been aware of the applicability of the Venezuelan Constitutional Law. As argued in the invalidity claims, any diligent investor should have been aware of the invalidity risks because the September Resolution was publicly discussed and approved, as was widely reported by news. Even more importantly, in September 2016, the Venezuela constitutional situation received wide attention because of the several unlawful measures adopted by the Government of Nicolas Maduro to disown the constitutional authority of the National Assembly elected in 2015, including the authority to oversee the national public interest contract of PDVSA.

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More importantly, the constitutional provisions applicable to the 2020 Notes were in force at the moment of their issuance. Additionally, at that time, several rulings of the Supreme Tribunal, scholarly opinions, and resolutions consistently concluded that PDVSA was subject to the constitutional framework governing contracts of national public interest, including the mandatory authorization by the National Assembly. This Constitutional Law framework was reflected in the Resolution dated September 27, 2016, which denied PDVSA the authority to pledge the shares. At the moment of the issuance of the 2020 Notes, the Constitutional Law of Venezuela clearly demonstrated the invalidity of the Notes due to the lack of parliamentary authorization to pledge the shares.

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In short, the argument regarding contracts of national public interest was not a contrivance to evade PDVSA's obligations but a consistent argument in line with the Constitutional Law in force at the time.

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Through abusive constitutional mechanisms (such as emergency decrees), the Government of Venezuela decimated the authority of the Legislative Branch, particularly regarding parliamentary controls over PDVSA. Nevertheless, before issuing the 2020 Notes, the National Assembly clearly warned that PDVSA did not have the authority to pledge Citgo shares. When the indenture and pledge agreements were executed, it was evident that PDVSA did not have the constitutional authority to pledge the shares.

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This landmark decision should introduce significant changes regarding the interaction between Constitutional Law and New York choice-of-law clauses, especially concerning emerging markets in the so-called Global South. This conclusion is particularly relevant considering how Constitutional Law in the Global South regulates public debt transactions, encompassing accountability, transparency, development, and environmental protection. The result should be a more constructive relationship between financial markets and those Constitutional Law provisions.