The Endgame: An Analysis of Puerto Rico’s Debt Structure and the Arguments in Favor of Enacting a Comprehensive Debt Restructuring Mechanism for Puerto Rico

Puerto Rico’s debt structure is inordinately complicated. With no access to a broad debt restructuring mechanism, the chaos that a disorderly default could bring would further erode bondholder value, increase restructuring costs, depress the local economy, and make long-term recovery harder to achieve.

What follows is the executive summary of the policy paper “The Endgame: An Analysis of Puerto Rico’s Debt Structure and Arguments in Favor of Enacting a Comprehensive Debt Restructuring Mechanism for Puerto Rico” updated on April 2016.

A link to the updated paper in its entirety can be found at the end of this post.


A HIGHLY COMPLEX DEBT STRUCTURE

Puerto Rico’s debt is spread across a variety of issuers and debtors, which creates a complex web of intermingled securities and competing claims:

  1. First in line are General Obligation bonds backed by the good faith, credit and taxing power of the Commonwealth, which would sit right in the middle of our imaginary set of concentric circles.
  2. Second in terms of bondholder protections would be Bonds and Notes Guaranteed by the Commonwealth’s Good Faith and Credit. In theory, bonds and notes guaranteed by the Commonwealth are considered “public debt” for purposes of the Constitution and enjoy the same priority of payment and protection.
  3. Third in line would be bonds issued by the Puerto Rico Sales Tax Financing Corporation, otherwise known as COFINA, which are secured by a statutory lien on certain sales tax revenues that have been pledge for the repayment of its bonds.
  4. Next in line are bonds issued by the Municipal Finance Agency. These bonds are secured by ad valorem taxation, without limitation as to rate or amount, on all taxable property within the issuing municipalities.  The good faith, credit and unlimited taxing power of each issuing municipality are pledged for the payment of its general obligation municipal bonds and notes.
  5. Fifth in line would be revenue bonds issued by Puerto Rico State-Owned Enterprises or Public Corporations, as they are commonly known. These bonds are payable solely from the revenues generated by each of these public corporations, with the exception, as we stated above, of those public corporation bonds that have been expressly guaranteed by the Commonwealth of Puerto Rico.  Bondholder rights and remedies are expressly set forth in the Trust Indentures executed by each state-owned enterprise.
  6. Sixth in line is debt supported by Commonwealth Appropriations or Taxes. These obligations depend on action(s) by the Puerto Rico legislature for their repayment.  Bondholders, in general, cannot sue at law or equity to require that a law be enacted, thus, their expected recovery is essentially at the mercy of the political process.
  7. Seventh in the line-up would be bonds issued by the Employees Retirement System. These bonds are payable solely from 
employer contributions made to the Employees Retirement System by the Commonwealth and its instrumentalities after the issuance of the bonds.  The Commonwealth does not guarantee such bonds.
  8. Finally, limited obligation and non-recourse debts offer the weakest bondholder protection.

UNRESOLVED ISSUES AND OPEN QUESTIONS

Despite these protections, the existing regulatory and legal framework is ambiguous, with several untested and unresolved issues that make for a potentially disorderly process in the case of creditor lawsuits:

  1. Open Issue #1/GO’s: The Spanish and English versions of the Puerto Rico Constitution contain slightly different wording for Article VI, Section 8, which establishes the first claim on Commonwealth resources. The Spanish version talks about “recursos disponibles” (available resources), while the English version reads “available revenues” (ingresos disponibles).
  2. Open Issue #2/GO’s: While GO bondholders may have a “first claim” on “available resources” (regardless of how they are defined) of the Commonwealth it is not clear what remedies they may seek in order to enforce that claim.
  3. Open Issue #3/COFINA: According to an opinion of the Secretary of Justice of the Commonwealth, the portion of the Commonwealth sales and use tax allocated to COFINA is not “available” for the payment of principal of and interest on General Obligation bonds.  The validity of this legislative allocation, however, has not been challenged in or ruled upon by any court and thus remains an open question.
  4. Open Issue #4/COFINA: Article VI, Section 7 of the Puerto Rico Constitution states that “The appropriations made for any fiscal year shall not exceed the total revenues, including available surplus, estimated for said fiscal year unless the imposition of taxes sufficient to cover said appropriations is provided by law.”  Most of the proceeds of COFINA bond offerings were in fact used for deficit financing or to cover current expenses, financial uses that prima facie appear to be Constitutionally prohibited.  However, in the absence of a court decision this legal issue remains open to judicial interpretation.
  5. Open Issue #5/ Municipal Finance Agency: Do municipal tax revenue streams constitute “available resources” and thus are subject to the Constitutional Clawback to pay GO bondholders?  To the best of our knowledge this is an unresolved legal question.
  6. Open Issue #6/State-Owned Enterprises: In 2012, PRASA issued approximately $2 billion worth of bonds secured with a pledge on its gross revenues. Thus, holders of these bonds could claim that their lien is not subject or subordinated to the payment of PRASA’s operating expenses.  PRASA’s options at that point presumably would be to default or increase its rates to pay for its operating expenses.  However, how would a court ultimately resolve this issue is an open legal question.
  7. Open Issue #7/Constitutional Priorities: Article VI, Section 8 of the Puerto Rico Constitution sets a statutory “waterfall” which provides some guidance as to how government funds would be allocated in the event of a liquidity crisis. However, the statutory language is so ambiguous as to practically invite litigation. In summary form, these priority norms are:
    • First, the payment of the interest on and amortization requirements of the public debt (again, defined to include only Commonwealth general obligations and guaranteed debt for which the Commonwealth’s guarantee has been exercised);
    • Second, the fulfillment of obligations arising out of legally binding contracts, court decisions on eminent domain, and other unavoidable obligations to protect the name, credit and good faith of the Commonwealth;
    • Third, current expenditures in the areas of health, public safety, education, welfare, and retirement systems; and
    • Fourth, for all other purposes.

THE NEED FOR A COMPREHENSIVE DEBT RESTRUCTURING MECHANISM

Allowing the Commonwealth of Puerto Rico and its distressed agencies, instrumentalities, and municipalities access to a comprehensive debt restructuring mechanism is in the best interests of all stakeholders of the Puerto Rico crisis, including bondholders and U.S. taxpayers:

  1. First, bankruptcy protection is not a federal bailout as it would not cost the federal government a single cent. Furthermore, it could be argued that the probability of a bailout by the federal government would increase significantly if Puerto Rico and its agencies and instrumentalities were not allowed to restructure their debt.
  2. Second, Puerto Rico’s debt is spread across a variety of debtors (18 issuers in total) representing a complex web of claims in an uncertain regulatory and legal framework. A court-supervised process would help ensure fair treatment to all parties, including small, retail investors currently not “at the table”. The alternative—an untested and potentially disorderly process with numerous creditor lawsuits and years of scorched-earth litigation—would depress the local economy, increase restructuring costs, and make long-term recovery harder to achieve. In sum, no one benefits from the chaos of a disorderly default, years of nonpayment, protracted multi-forum litigation, and social unrest in Puerto Rico.
  3. Third, a restructuring regime could provide essential protections to all parties: a stay on creditor collection actions, priority for new private short-term cash flow financing, and voting by creditor classes on any proposed restructuring.
  4. Fourth, an orderly debt restructuring process would allow Puerto Rico to ensure the uninterrupted provision of essential public services.
  5. Fifth, postponing the inevitable restructuring only increases economic and social costs over the long-term.

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