US SANCTIONS AND THE RIGHT OF BORROWERS TO WITHHOLD REPAYMENT: COMMERCIAL COURT SIGNALS RETURN TO ORTHODOXY

The Commercial Court has granted summary judgment in favour of a bank seeking to recover payments under Credit Agreements entered into with the Venezuelan state-owned oil and gas company, Petroleos De Venezuela SA (PDVSA), finding that the defaulting borrower had no real prospect of successfully defending the claims on the basis of certain US Sanctions imposed on Venezuela which post-dated the execution of the Credit Agreements: Banco San Juan Internacional Inc v Petroleos De Venezuela SA [2020] EWHC 2937 (Comm).

The court rejected all of the arguments put forward by PDVSA as to why it was prevented from making repayments as a result of the imposition of US sanctions (PDVSA is now a US Specially Designated National (“SDN”)). In particular, the court made the following findings, which will be of broader interest to global lenders with exposure to borrowers facing sanctions risk:

1. No “normal course” to suspend payment obligations where there is a risk of US Sanctions

In interpreting the sanctions clause in the Credit Agreements, the court rejected the suggestion that the Court of Appeal’s recent decision in Lamesa Investments Limited v Cynergy Bank Limited [2020] EWCA Civ 821 demonstrated that it is perfectly normal and sensible in commercial agreements to suspend payment obligations where payment would otherwise be in breach of US sanctions (see our banking litigation blog post). It found that this authority (and others) were simply decisions on their (very different) facts. On the facts of the present case, the court concluded that the relevant clause provided no basis for a suspension of the repayment obligations (and in any case it was not clear that it would in fact be a breach of sanctions for PDVSA to make payment).

This represents a move back to orthodoxy in cases of this kind, emphasising the importance of the contractual construction of the particular wording of the clause in each case. Lamesa v Cynergy was a surprising decision in part because the party with the payment obligation in that case was (if payment was made) only at risk pursuant to US secondary sanctions. Here, US primary sanctions were in play to some extent, given that the payment was to be made in US dollars and to a US account. Nonetheless, the court found that PDVSA’s payment obligation was not suspended. As such, it appears that the outcome in Lamesa v Cynergy does not have broader application – instead, as the court itself observed in Lamesa, each case will turn on the  interpretation of the particular contract in question.

2. Impossibility vs impracticability of repayment

On an obiter basis, the court expressed the view that it was merely impracticable and not illegal for PDVSA to make payments in USD to a US bank account, because: (i) it was not illegal for PDVSA (a non-US entity based outside the US) to initiate payment; and (ii) it was possible for the parties to vary the Credit Agreements and make payment in euros to a bank outside the US. Accordingly, the court doubted that PDVSA could rely on the “very narrow gateway” in Ralli Bros v Compania Naviera Sota y Aznar [1920] 2 KB 287 (providing that English law governed contracts are unenforceable where performance is prohibited in the place of performance).

3. Burden of proving that US Sanctions prevent contractual performance

Even if the US Sanctions prima facie rendered the performance of PDVSA’s payment obligations necessarily illegal at the place of performance, the court found that PDVSA had an obligation under the Credit Agreements to apply for a licence from the US Office of Foreign Assets Control (OFAC) in order to make the payments, which it had failed to discharge. As an important point of general application, the court stated that (absent any contractual provision to the contrary or a statutory reversal), the legal burden to obtain the necessary licence to effect the repayments was on PDVSA (as the debtor and the party bound to perform).

The decision is considered in more detail below.

Background

PDVSA is a Venezuelan state-owned oil and gas company, exclusively operating the Venezuelan oil and gas reserves, which are among the largest in the world. In 2016 and 2017, PDVSA borrowed sums under two Credit Agreements that it entered into with the Puerto Rican bank, Banco San Juan Internacional Inc (the Bank). On PDVSA’s case, this was part of a broad trend by which Venezuelan business interests were moved away from the mainland US financial system to Puerto Rico (an unincorporated territory of the US) as a result of political pressure from the US on Venezuela.

PDVSA defaulted on payments under both Credit Agreements, which contained English law and exclusive jurisdiction clauses in favour of the courts of England and Wales.

The claims

The Bank brought two claims in debt against PDVSA in this jurisdiction:

1. 2016 Credit Agreement: A claim for US$48 million comprising overdue principal and accrued default interest and costs; and
2. 2017 Credit Agreement:A claim for US$38 million comprising the loss of anticipated profits under the agreement, accrued default interest and costs. By way of brief explanation, following PDVSA’s payment defaults under this agreement, the loan was accelerated on 3 December 2018 and monies in certain trust accounts were used to discharge the overdue principal and interest then owed under the agreement. The liability under this agreement therefore rested on Clause 3.04(c) of the 2017 Credit Agreement to compensate the Bank for “the loss of anticipated profits equal to the Present Value of all fees and interest payable to [the Bank] through the Final Maturity Date of each Loan“.

The Bank applied for summary judgment on both claims. PDVSA argued that it had a real prospect of successfully defending the claims, primarily because of the effect of certain US Sanctions imposed on Venezuela which post-dated the execution of the Credit Agreements (in particular Executive Order 13850 and Executive Order 13884, detailed below). In the alternative, PDVSA argued that the sum claimed under the 2017 Credit Agreement was a disproportionate penalty, and that the sums claimed by way of costs and expenses under the terms of the Credit Agreements were not reasonable and within the scope of the indemnity.

Decision

The court granted summary judgment in favour of the Bank on both claims. We consider below the principal grounds of defence rejected by the court that are likely to have broader application.

Imposition of US Sanctions

PDVSA said that it wanted (and had the funds) to repay the Bank under the Credit Agreements, but that this was not possible because of the US Sanctions imposed on Venezuela.

PDVSA relied in particular on Executive Order 13850 (issued by President Trump on 1 November 2018, implementing blocking sanctions against persons operating in the gold sector of the Venezuelan economy, and creating an executive power for further sectors of the Venezuelan economy also to be blocked in due course) and Executive Order 13884 (issued by President Trump on 5 August 2019, a general blocking sanction freezing all property held by the Venezuelan government, including PDVSA).

As a consequence of the US Sanctions, PDVSA argued as follows (set out together with the court’s response):

1. The terms of the Credit Agreements, properly construed, suspended PDVSA’s payment obligations

The issue here was whether the sanctions clause in the Credit Agreements operated as a condition precedent to PDVSA’s liability (such that, if it was triggered, it would suspend PDVSA’s payment obligations – PDVSA’s case), or whether it was a negative covenant for the Bank’s benefit, but did not impact PDVSA’s liability to make payment (the Bank’s case). PDVSA relied on the decisions in Mamancochet Mining Limited v Aegis Managing Agency Limited [2018] EWHC 2643 (Comm) and Lamesa v Cynergy to argue that it is perfectly normal and sensible in commercial agreements to suspend payment obligations where payment would otherwise be in breach of unilateral US Sanctions.

The court found that these authorities were simply decisions on their (very different) facts.

The specific clause of the Credit Agreements relied on by PDVSA (Section 7.03), stated as follows:

“Sanctions. [PDVSA] will not repay Loans with the proceeds of

(a) business activities that are or which become subject to sanctions, restrictions or embargoes imposed by the Office of Foreign Asset Control of the U.S. Treasury Department, the United Nations Security Council and the U.S. Department of Commerce, the U.S. Department of State [sic] (collectively, ‘Sanctions’); or

(b) business activities in/with a country or territory that is the subject of Sanctions (including, without limitation, Cuba, Iran, North Korea, Sudan and Syria) (‘Sanctioned Country’)”.

This clause was contrasted with the relevant clause in Lamesa, which expressly provided for non-payment and was part of the payment obligation in the contract (unlike the present case, where there was no express mention of non-payment and the relevant clause was under the “Sanctions” heading). The court also noted that in Lamesa, the court of Appeal found good reasons for the existence of the non-payment provision.

Having found that the authorities did not suggest that it was a normal course for parties to contract to suspend payment obligations where there is a risk of US Sanctions, the court proceeded to consider the debate between the parties as to whether the clause was a condition precedent or a negative covenant. The court agreed with the Bank that the construction of the clause as a negative covenant was clear, in particular from the express wording of the clause and the structure of the agreement (under the “Sanctions” heading and separate from the payment obligations). The fact that the clause did not mention suspending the payment obligation was a notable contrast with another explicit suspension mechanism in the contract (in favour the Bank) and consistent with this construction.

The court therefore concluded that Section 7.03 provided no basis for a suspension of the repayment obligations by the terms of the Credit Agreements.

The court also went on to say that there were considerable doubts as to whether the relevant US Sanctions activated Section 7.03 at all (although it did not need to decide the point, given its primary finding). This will be interesting for those who wish to draft sanctions clauses which will be triggered by payment by a party who becomes an SDN. The doubt expressed by the court was on the basis that (a) the US sanctions against Venezuela were not country-wide; (b) the US sanctions were not such that PDVSA’s “business activities” were “subject to sanctions”, and (c) PDVSA had historical assets derived from its activities before the sanctions came into effect, held outside the US, and Section 7.03(a) would not apply to such assets.

2. By reason of the rule in Ralli Bros, English law governed contracts are unenforceable where performance is prohibited in the place of performance, which in this case was the US

PDVSA relied on the rule in Ralli Bros to assert that it could not perform the Credit Agreements in accordance with US law. Primarily, this was because PDVSA said it could not pay and the Bank could not receive funds into the “Stipulated Account”, which was located in the US. However, even if they could, PDVSA highlighted that the payments under the Credit Agreements were required to be made in USD, and a significant USD transaction would need to clear the US financial system (via a correspondent bank), from which PDVSA was excluded.

The court found that – even if the US Sanctions prima facie rendered the performance of PDVSA’s payment obligations necessarily illegal at the place of performance – PDVSA had no reasonable prospects of success on this ground of defence. This was because the prohibitions in the US Sanctions were qualified and PDVSA could have applied for a licence from OFAC in order to make the payment into the Stipulated Account. The court found that (absent any provision to the contrary in the Credit Agreements, or a statutory reversal), the legal burden to obtain the necessary licence to effect the repayments was on PDVSA (as the debtor and the party bound to perform). Further, in this case the court found that the Credit Agreements explicitly put the burden on PDVSA. However, PDVSA failed to show that it had discharged its obligation to apply for a licence, or that (had it applied) the application would have failed.

Although unnecessary given its finding on the licence issue, the court considered (obiter) whether making payments into the Stipulated Account would have been illegal, and therefore engaged the Ralli Bros doctrine. In this context, the court noted that the rule in Ralli Bros operates as a limited exception to the general rule that illegality under foreign law does not frustrate or otherwise relive a party from performance of an English law contract (see for example, Canary Wharf (BP4) T1 Ltd v European Medicines Agency [2019] EWHC 335 (Ch) and our litigation blog post). The court emphasised that the doctrine offers a narrow gateway: the performance of the contract must necessarily involve the performance of an act illegal at the place of performance and will not apply where the contract could be performed some other way which is legal, or if the illegal act has to be performed somewhere else.

In contrast to these requirements, the court said the issue of making payment to the Stipulated Account in the US was not one of illegality, but rather impracticability: it was not illegal for PDVSA (a non-US entity based outside the US) to initiate a payment, and it was not clear that it was illegal for the Bank to receive it (if the funds were then blocked). In any event, in the court’s view there was plainly a possibility of payment being made in euros to a bank outside the US, by variation of the Credit Agreements, to which the Bank would have been amenable. Accordingly, the court doubted that the “very narrow gateway” of Ralli Bros was engaged.

3. Article 9(3) of Rome I (Regulation No 593/2008/EC) confers a discretion on the court to apply mandatory overriding provisions of the law of the place of performance (here, US law) to a contract governed by another law (English law) and that this discretion should be exercised in this case

The court concluded that there was no real prospect of success on this argument, particularly in circumstances where the Ralli Bros defence covered similar ground to Article 9(3), but operated without any discretionary element.

Penalty argument

PDVSA argued that the sum claimed under the 2017 Credit Agreement was a disproportionate penalty, imposed for breach of the primary sums due under the 2017 Credit Agreement, and despite the fact that the primary sums have already been recovered in full.

The court had no difficulty at all in concluding that the clause was not a penalty and that PDVSA’s argument had no real prospect of success. As this was in essence a question of construction, the court found it was an appropriate issue on which to come to a final conclusion on a summary judgment application.

It was common ground that the leading authority on penalty clauses is Makdessi v Cavendish Square Holding BV [2015] UKSC 67 (see our litigation blog post), which provides that to find that a provision is an unenforceable penalty, it must be: (i) a secondary obligation; (ii) triggered on breach of contract; which (iii) imposes a disproportionate detriment on the contract breaker.

In this case, the court said that the three limbs of the Makdessi test were intertwined. Looking at the contract as providing an overall agreement for a particular return over the lifetime of the contract, the court commented that “…not only does the mathematics inexorably drive the conclusion that the sum involved is in no way disproportionate, but also suggests that the obligation is a primary one and not a sum due (even in substance) on breach.”

The court therefore found that the clause was not a penalty and granted summary judgment in favour of the Bank on both the 2016 and 2017 Credit Agreements.

For more information, please contact Susannah Cogman, Partner, Ceri Morgan, Professional Support Consultant, or your usual Herbert Smith Freehills contact.