COFINA and the “Good Enough” Restructuring Doctrine

Martillo juez y dinero

COFINA and the “Good Enough” Restructuring Doctrine

Published on February 12, 2019 / Leer en español

Sergio portrait
Policy Director


On February 4, Judge Laura Taylor Swain issued (1) A Memorandum Opinion and Order Approving Settlement Between Commonwealth of Puerto Rico and Puerto Rico Sales Tax Financing Corporation (the “Commonwealth – COFINA Settlement”) and (2) A Memorandum of Findings of Fact and Conclusions of Law in Connection with Confirmation of the Third Amended Title III Plan of Adjustment of Puerto Rico Sales Tax Financing Corporation (the “POA Confirmation Order”).

These two documents were issued in connection with the resolution of a petition filed by the Financial Oversight and Management Board for Puerto Rico, as the representative of the Commonwealth of Puerto Rico, pursuant to Title III of the Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”) to restructure debt issued by the Puerto Rico Sales Tax Corporation, known as COFINA, and to address other legal issues arising out of the issuance of bonds by COFINA.

The Commonwealth – COFINA Settlement

From the start, he Judge makes clear that her decision regarding the Settlement Agreement of the Commonwealth-COFINA dispute is limited in scope. According to the Judge, the only question before her is “whether to approve an agreement embodying a settlement that divides rights to a significant flow of tax revenues between two debtors—the Commonwealth of Puerto Rico and COFINA—that have been involved in complex litigation concerning claims, on the one hand, that the Commonwealth previously made a valid transfer of the disputed tax revenue stream to COFINA to support the repayment of billions of dollars of bonds and, on the other hand, that the Commonwealth did not have the power to transfer rights to the revenue stream to COFINA or did not make the transfer in an effective way.” (p. 3)

By framing the issue in this limited way, the Judge accomplishes several things. First, she is free to disregard certain objections to the Settlement Agreement, that while valid and “logical”, she essentially deems to be irrelevant in the context of the dispute between the Commonwealth and the COFINA bondholders. According to the Opinion:

Many of the formal and informal objections raised serious and considered concerns about the Commonwealth’s future ability to provide properly for the citizens of Puerto Rico who depend upon it. These objections argued that, if the Commonwealth does not have full access to the tax revenues that are the subject of the Commonwealth-COFINA Dispute, it will not be able to provide a sufficiently robust foundation for population retention and economic growth as it works to overcome its current crisis. The concerns are logical, and reflect well-founded anxieties of citizens about issues that the Oversight Board and the elected government will have to address in responsible, meaningful ways in formulating a plan of adjustment for the Commonwealth. They are not, however, concerns upon which the Court can properly act in making its decision on the current motion pursuant to Rule 9019. The question now before the Court is much narrower— whether this particular Settlement Agreement should be approved as a resolution of the dispute between two Title III debtors over the stream of tax revenue. (p. 4)

Second, by narrowly framing the issue before the court, the Judge only has to decide whether the parties “have reached a negotiated result that is within the range of reasonable results.”, a rather low bar, that allows her to avoid thorny issues of constitutionality, representation, transparency, sustainability, and legal precedent.

After acknowledging that the Settlement Agreement represents a “compromise that is, admittedly, deeply disappointing to countless citizens of Puerto Rico and investors in Commonwealth bonds” the Judge undertakes a lengthy recount of the dispute and the procedural path that led to the eventual settlement.

Representation Issues

In essence, the dispute centered on the allocation between COFINA and the Commonwealth of the tax revenues generated by 5.5 percentage points of the 11.5% sales and use tax imposed by the Commonwealth. The parties agreed to split that amount, with 53.65% allocated to COFINA and 46.35% allocated to the Commonwealth.

The Judge then describes the complex mediation process she set up and through which the parties negotiated behind closed doors. The participants in the mediation were (1) the Official Committee of Unsecured Creditors of the Commonwealth of Puerto Rico (the “UCC”), as agent of the Financial Oversight and Management Board for Puerto Rico (the “FOMB”), as representative of the Commonwealth of Puerto Rico, and (2) Ms. Bettina Whyte (a private consultant), as agent of the Financial Oversight and Management Board for Puerto Rico, as representative of the Puerto Rico Sales Tax Financing Corporation.

Which begs the question: Who, if anyone, represented the interests of the people of Puerto Rico in this process? After all, it is the people of Puerto Rico, not the UCC, the FOMB, the Commonwealth government, Ms. Whyte, or COFINA, who will have to live with the consequences of the Settlement Agreement. The Judge reassures us that the Agreement in Principle, which set forth the terms and conditions for the split of the disputed tax revenues, “was the product of arm’s length negotiations between the Agents free from any influence or direct participation by the Oversight Board”, which is nothing more than cold-comfort given that neither Agent was appointed by, or acted as a direct representative of, the people of Puerto Rico.

Then the plot thickens. On page 11 the Judge informs us that the Oversight Board objected to the Agreement in Principle. Specifically, the FOMB “asserted that certain aspects of the Agreement in Principle concerned matters beyond the scope of the Commonwealth-COFINA Dispute, as framed by the Procedures Order and the Scope Orders, including the design of new securities to be issued under a plan of adjustment for COFINA and a requirement on how the Oversight Board may use funds allocated to the Commonwealth.”  This begs the question of what exactly were the Oversight Board’s objections?

However, eventually the FOMB had an unexplained change of mind and “determined, after reviewing the extensive litigation history and issues raised in the Adversary Proceeding and assessing the likelihood of success for the Commonwealth in the litigation, that the central component of the Agreement in Principle—the 53.65% / 46.35% allocation of the disputed sales and use tax revenue between COFINA and the Commonwealth, respectively—was a fair and reasonable settlement and compromise of the Commonwealth-COFINA Dispute given the substantial risks of litigation, and determined to build upon the central component of the Agreement in Principle to garner support for a confirmable COFINA plan of adjustment.” (p.12)

As we will see later, the Judge gives a lot of weight to the “substantial risks of litigation” in her analysis of the reasonableness of the Settlement Agreement. However, the more immediate concern of the FOMB appears not to have been the risk of litigation but rather the unwillingness of the UCC to “finalize any further documentation regarding the Agreement in Principle” due to changes in the Commonwealth’s then-certified fiscal plan. (p .12) Again, it is not clear why the UCC took this position and perhaps we will never know.

At this point, the FOMB abandoned its “hands-off” posture (to the extent that ever was its true posture) and began negotiation of the Settlement Agreement with the COFINA Agent. The Judge, again, goes out of her way to reassure us that the FOMB “did not exert any influence on the COFINA Agent’s decision to enter into the Settlement Agreement, nor did the COFINA Agent permit the Oversight Board to affect her judgment or ability to carry out her duty to act in the best interest of the debtor she was appointed to represent.” But, in the end, it was the unelected FOMB which negotiated the Settlement Agreement with the COFINA Agent, in a way negotiating with itself.

This convoluted procedural history just highlights the cumbersome and unwieldy process set up by PROMESA and the true lack of representation of the people of Puerto Rico in this entire process, where people with three or four degrees of separation from Puerto Rico make decisions literally behind closed doors that will affect us for the next forty years.

The Settlement Agreement

Having finished the long and winding procedural narrative of the mediation process, the Judge then moves on to the legal analysis of the Settlement Agreement. Right off the bat, she asserts that the issues involved in the Commonwealth-COFINA dispute are “novel, complex, and of great importance to the people”.  In essence:

The Commonwealth Agent has asserted a number of challenges to the constitutionality of the transfer of the Pledged Sales Taxes to COFINA under the Commonwealth Constitution’s debt limit, debt priority, and balanced budget provisions. Conversely, the COFINA Agent has asserted its own claims, including that the Legislative Assembly properly exercised its broad taxing and police powers to enact legislation transferring the disputed sales tax revenues to COFINA, that the debt limit provisions of the Commonwealth Constitution do not prohibit the transfer of the Pledged Sales Tax to COFINA, that the balanced budget provision of the Commonwealth Constitution does not preclude the transfer of sales tax revenues to COFINA, nor is it applicable to the COFINA Bonds, and that the plain language of Act 91 transferred ownership of the Pledged Sales Taxes to COFINA. (p. 16)

The curious thing is that having just asserted the novelty and importance of the legal issues at hand, the Judge then proceeds to make a lengthy argument for not litigating them and for the parties to accept the terms of the Settlement Agreement.

According to the Memorandum Opinion the standard to approve a settlement pursuant to Bankruptcy Rule 9019 only “requires a court to assess whether the [proposed] settlement falls below the lowest point in the range of reasonableness.”

In the context of a bankruptcy proceeding, the court must consider four factors in assessing the reasonableness of a settlement: “(i) the probability of success in the litigation being compromised; (ii) the difficulties, if any, to be encountered in the matter of collection [of the disputed funds]; (iii) the complexity of the litigation involved, and the expense, inconvenience and delay attending it; and, (iv) the paramount interest of the creditors and a proper deference to their reasonable views…”(p. 16)

With respect to the first factor, the Court is of the opinion that the Commonwealth’s likelihood of prevailing in litigation is uncertain. But, while this is true for the Commonwealth, it is also equally true for COFINA. After all, none of the Puerto Rico Constitutional or statutory issues raised in the Commonwealth-COFINA dispute have ever been addressed by a Puerto Rican court, or any court for that matter. Given the lack of precedent, an unbiased Judge could have ruled either way.

Furthermore, the Judge appears to be of the opinion that a litigated outcome “would likely have produced an all-or-nothing result”. (p. 20). This however is far from certain in the best case and an absolute non-sequitur in the worst. There is no logical reason to assume that any such litigation would have resulted in an all or nothing result. Again, given the lack of precedent, an unbiased judge could have allocated the disputed tax revenues in any number ways. The Judge just seems to have assumed a worst-case scenario outcome for the Commonwealth.

The Judge considers the second factor, “the difficulties, if any, to be encountered in the matter of collection of the disputed funds”, not to be significant, as the disputed revenues are expected to continue to be collected.

However, the third factor, regarding the complexity of the litigation subject of the settlement, the Judge finds to be quite significant. And she is right:

All parties in interest asserted equally divergent views regarding, among other things, whether (a) Act 91 did or did not transfer to COFINA a present property interest in potential future tax revenues, (b) there was or was no “true sale” of future tax revenues by the Commonwealth to COFINA, (c) Act 91 did or did not transfer to COFINA the Commonwealth’s “right to receive” future tax revenues, and (d) the COFINA structure, Act 91 and the purported sales tax revenue transfer are or are not constitutional. (p. 17)

Again, the Judge stresses that given the “all-or-nothing nature of the most likely potential outcomes of the Commonwealth-COFINA dispute and the accompanying risk of an outcome adverse to the Commonwealth and, whatever the outcome, of appeals and petitions for Supreme Court review, it is both rational and reasonable for the Oversight Board to compromise as it has opted to do in the Settlement Agreement before the Court…The Court therefore concludes that the proposed Settlement Agreement is well within the range of reasonable alternatives that are beneficial to the Commonwealth.” (p. 22)

The irony here is that by approving the Settlement Agreement the Judge has essentially ensured that these important, novel, and complicated questions of law remain unanswered, suspended in a legal limbo, for the foreseeable future. In this sense the opinion is the legal equivalent of a “scoop and toss” financing. It just kicks the can down the road for other people to deal with the mess later.

Furthermore, and perhaps more pernicious, by avoiding the litigation of these admittedly complicated issues, many of first impression, Judge Taylor Swain has left in place the entire legal infrastructure that allowed Puerto Rico to get into this debt crisis in the first place. Given human nature, the boundless greed of bankers, the eternal vanity of politicians, and the bleak experience of multiple developing countries after defaulting and restructuring their debts, it is quite within the realm of the probable that, ten or twenty years down the road, we will see the government of Puerto Rico and its financial advisors peddling new debt offerings through COFINA (if it complies with the “Additional Bonds Test”) or a COFINA-like entity, by taking advantage of the legal ambiguities left unaddressed by avoiding litigation today. Yes, litigation can be costly and risky, but so can be the avoidance of litigation.

The fourth and final factor, requires the Court to consider the interests of the creditors. Not surprisingly, the Judge finds the Settlement Agreement is in the best interests of the creditors as it provides certainty that they will receive a portion of the tax revenues subject to dispute and avoids the risk of a court judgment that could have left the Commonwealth with none of the pledged sales tax revenues  for decades to come.

Finally, the court reiterates that:

Although many objectors and commenters are deeply and sincerely concerned that the Commonwealth may not ultimately have enough resources to reorganize its own finances and provide for essential services and economic growth, these concerns are not pertinent to the one question that is before the Court on this motion practice: the reasonableness of this settlement. The Court must decide whether the compromise with respect to this particular asset is reasonable in the context of the dispute about this asset. Its value and the relative strengths of the Commonwealth’s and COFINA’s legal claims to it are not measured by reference to the Commonwealth’s other needs. (p. 23)

So, while there are valid and serious concerns regarding the Settlement Agreement and its impact on the Commonwealth finances and its ability to provide essential services in the future, these concerns are not relevant to the case at bar. Furthermore, while in our view the Settlement Agreement raises as many questions as it settles, the Court finds it is “well within the range of reasonable alternatives that are beneficial to the Commonwealth.” (p. 22)  In other words, it may not be the best deal, but it appears to be “good enough” for the Commonwealth and its creditors.

The Plan of Adjustment Confirmation Order

The Order confirming the POA covers a lot of the same ground as the Order confirming the Settlement Agreement, but a couple of issues stand out.

Feasibility and Reasonableness of the POA

First, when analyzing the feasibility of the POA the Court engages in a kind of circular reasoning that is particularly troubling. According to the POA Confirmation Order:

The COFINA Fiscal Plan, certified on October 18, 2018, demonstrates that the Plan is feasible, because the COFINA Fiscal Plan provides for the incurrence of obligations contemplated by the Plan and shows that such obligations can be repaid. COFINA’s Fiscal Plan projections (as set forth in greater detail in Section XVIII of the Disclosure Statement, entitled “Financial Information and Projections” and Exhibit E thereto) demonstrate, as a result of COFINA’s ownership of the COFINA Portion, COFINA’s ability to fulfill its obligations under the Plan. COFINA’s financial projections (and its underlying assumptions) are reasonable and demonstrate a probability that COFINA will be able to satisfy its obligations under the Plan. (See Brownstein Decl. ¶¶ 29-34.) (p. 56)

So, the POA is feasible because the COFINA Fiscal Plan provides for the incurrence of new COFINA securities and shows such obligations issued pursuant to the POA can be repaid. Notice, however, that the Judge never directly addresses the question of whether the proposed reduction in the principal amount of COFINA bonds is reasonable or sustainable. In this sense, the Judge appears to overestimate the risk of what she believes to be is the worst-case scenario for Puerto Rico, namely, that the Commonwealth loses access to a share of the pledged sales tax revenues. But that is not the worst case scenario for Puerto Rico, not really. The worst case scenario for the Commonwealth would be having to renegotiate the new COFINA bonds within five or seven years, a risk the Judge seems to underestimate.

Furthermore, the Court asserts without any critical analysis or rigorous methodological assessment that COFINA’s financial projections and its underlying assumptions are “reasonable.” Now we find this statement extremely problematic because without “appropriate methods and forms of analysis it is simply not possible to know whether the POA is feasible or reasonable.” (See Peter J. Hammer, “Letter to Judge Rhodes”, in The Journal of Law in Society, Vol. 17:1, 2015, pp. 19-44, analyzing the Expert Report Regarding the Feasibility of the City of Detroit Plan of Adjustment”).

The Court, to its credit, tries to get out of this epistemic trap but only by summarily and uncritically taking at face value Citigroup’s analysis of COFINA’s Fiscal Plan. This issue is so important that we believe it deserves we quote the relevant part of the Opinion at length:

Citi’s analysis of the COFINA Fiscal Plan showed that sound assumptions—that stimulus from disaster funds, structural and fiscal reforms to the Puerto Rico economy, and improvements in tax collection methods will maintain a robust amount of personal consumption in the Commonwealth—justify the COFINA Fiscal Plan’s SUT projections. (Brownstein Decl. ¶ 31.)

Citi’s analysis further showed that, because the SUT is a tax of general application covering a broad range of goods and services with few exceptions, more spending and buying in the Commonwealth generates greater SUT revenues. Government and private disaster funding will stimulate spending and buying, and in turn, bolster SUT revenues. Altogether, over $82 billion in disaster relief funding is projected from 2018 to 2033. Among other things, this funding will be distributed directly to individuals and families affected by Hurricane Maria and will support reconstruction on the island. Such funds are reasonably projected to stimulate spending in the Commonwealth and maintain robust SUT revenue projections. Government reforms including labor, energy and corporate reforms are projected, to increase Puerto Rico’s economic output by 0.95% by FY 2023. It is reasonable to assume that this economic growth will translate to growth in SUT revenues and that better tax collection methods and increased compliance efforts will yield a 5% increase in total SUT collected by 2021. (Brownstein Decl. ¶ 32.) (P. 66-67)

Thus, the Court, relying on the declaration of a paid expert, a banker really, (Managing Director and Co-Head of the Municipal Finance Department in Global Spread Products at Citigroup Global Markets Inc.), makes the extraordinary assumption that COFINA’s Fiscal Plan is sound because it is based on the “reasonable” assumptions regarding economic growth, consumption, the flow of stimulus funds, and the effects of structural reforms, that underlie the Commonwealth’s Fiscal Plan.

But wait, at the beginning of both the Opinion regarding the Settlement Agreement and the Opinion certifying the POA the Judge states that she cannot take into consideration objections that go beyond the scope of the Settlement Agreement or the POA and that such objections will be considered in a separate process for the Commonwealth.

For example, on page 7 of the POA Order the Judge states that: “It is important for all to bear in mind that the Plan before the Court addresses only COFINA’s assets and liabilities. It does not map the way forward for the Commonwealth of Puerto Rico. In formulating a separate plan for the Commonwealth, the Oversight Board and the elected Government will have to address the logical and well-founded concerns of citizens and creditors of the Commonwealth in responsible, meaningful ways.” (P. 7)

This is nothing more than judicial sleight of hand. Objectors to the Settlement Agreement and the COFINA POA are limited to the confines of the COFINA dispute and the text of the proposed POA. However, the Court is allowed to reach beyond the four corners of both the Settlement Agreement and the POA to rely on the economic growth forecast set forth in the Commonwealth’s Fiscal Plan. The Court’s analysis therefore is internally and logically inconsistent.

Furthermore, it takes at face value both the declaration of Mr. David Brownstein and the Commonwealth’s Fiscal Plan economic projections, without asking any questions about the methodology of those projections and forecasts; what is the margin error of each of the forecasts; whether multiple scenarios were prepared or analyzed; what are the downward risks to those forecasts; and what would be consequences if some those downward risks actually materialize.

This is more than an academic or hypothetical quibble. For example, the Judge states that the expected inflow of federal recovery funds can be “reasonably” expected to stimulate the economy, including consumption, and therefore sales tax revenue. And that is true.

However, the Court ignores the impact on the economy and on the feasibility of the COFINA POA of a delay in the obligation and disbursement of such federal funds; or if such funds are cut back; or spent mostly on contracts to firms based in the mainland. The same problem arises in the context of analyzing the effectiveness of the proposed structural reforms or if net migration increases during the forecast period. To uncritically assume that all the economic and fiscal forecasts set forth in the Commonwealth’s Fiscal Plan will actually be realized and materialized is, at best, analytical sloppiness, or to engage in magical thinking, at worse.

Access to the 5.50% of the SUT

One of the strongest selling points used by the Government of Puerto Rico, the FOMB, and the bondholders in support of both the Settlement Agreement and the COFINA POA, is that it gives access to the Commonwealth to a significant share of sales tax revenues that otherwise would go to COFINA. In fact, the Judge highlights the risk of the Commonwealth losing in litigation the right to such revenues as one of the strongest arguments in favor of the Settlement Agreement and the POA.

However, this argument is not quite correct. The Commonwealth’s right to access its “share” of the 5.50% of the sales and Use Tax is contingent and subordinated to the right to the first dollars that is granted to the COFINA bondholders.  On this point, the Court is crystal clear:

Critically, the COFINA Revenues comprise the first collections of the 5.50% SUT in each Fiscal Year. Thus, the debt service on the COFINA Bonds is backed by the entire amount of the 5.50% SUT because a shortfall will only exist in the event that the entire amount of the 5.50% SUT generated in a Fiscal Year is less than 53.65% of the Pledged Sales Tax Base Amount. (P. 66)

Therefore, the Government of Puerto Rico gets none of the COFINA Revenues unless and until COFINA receives the entire 53.65% of the Pledged Sales Tax Base Amount. Furthermore, the amount actually received by the Commonwealth on any given year will fluctuate according to economic growth, consumption expenditures, and tax enforcement efforts, which perhaps explains why the Government’s estimates of the amount it expects to receive as a consequence of this transaction fluctuate wildly.


Back in 2016, those who supported PROMESA argued that it would create an orderly process for the adjustment of Puerto Rico’s debts and provide a well-stocked legal tool kit to efficiently and effectively execute such adjustment. However, as we have demonstrated herein, it has yielded, at least in the case of COFINA, a process and a result that can only be charitably described as “good enough.” Furthermore, it appears to us that the Settlement Agreement and the COFINA POA generated by a court proceeding under the aegis of Title III of PROMESA have imposed severe economic, social, and political costs on the people of Puerto Rico, left important questions of law unanswered, and delivered insufficient debt relief. And that is simply unacceptable.