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Puerto Rico’s Audacious Move: Can it Cut its Debt by $6 bn?

posted by Mark Weidemaier

Mitu Gulati & Mark Weidemaier

Last week, the Government of Puerto Rico, acting through the Financial Oversight and Management Board (and in conjunction with the creditors’ committee), filed a claims objection seeking to invalidate roughly $6 billion of its General Obligation debt. The reason is that the government allegedly borrowed in violation of the Debt Service Limit and the Balanced Budget Clause of the Puerto Rican constitution. Stephen’s recent post on this subject discusses the merits of this argument in some detail. In this post, we are especially interested in the question of restitution. The Commonwealth doesn’t get much benefit from invalidating loans unless it also avoids the obligation to pay restitution (i.e., return the purchase price). So the objectors make the additional argument that bondholders have no equitable right to restitution under a theory of unjust enrichment.

There is some precedent for the objectors’ arguments in similar contexts, although not a lot of it. Some of the important cases, such as Litchfield v. Ballou (1885), are also very old. However, at least one law review article—a student note in the North Carolina Banking Institute journal (here)—squarely addresses Puerto Rico’s argument, ultimately concluding:

How can Puerto Rico’s penalty for illegally borrowing above its means be that it is allowed to declare the debts void and keep the money for itself? Despite the manifest unfairness of such a result, the applicable law indicates that this is likely the proper legal result.

It might seem unfair for bondholders to get nothing. But as a matter of basic contract law, there is a plausible argument against restitution. Here’s section 197 of the Restatement (Second) of Contracts: “[A] party has no claim in restitution for performance that he has rendered under or in return for a promise that is unenforceable on grounds of public policy unless denial of restitution would cause disproportionate forfeiture.” (The fact that bondholders will lose their expected payments does not make forfeiture “disproportionate.”) And here’s the most relevant exception, in section 198: “A party has a claim in restitution … if (a) he was excusably ignorant of the facts or of legislation of a minor character in the absence of which the promise would be enforceable, or (b) he was not equally in the wrong with the promisor.” Readers interested in this topic, which we think quite fascinating, should check out Juliet Kostritsky’s Illegal Contracts and Efficient Deterrence. To be clear, the Control Board bases its argument on the Commonwealth’s law—for example, on the proposition that the Constitution invalidates other provisions of law (including the UCC) that might provide bondholders a remedy. We reference elementary principles of contract law only to show that readers should not view the objectors’ arguments as demanding radical changes to well-established law. It’s quite clear that the law permits (if not requires) exactly the result the objectors seek to achieve.

Thus, while the objection has no doubt made some market participants apoplectic, it is not especially radical as a legal matter. Nor is it novel factually. Other governments have raised, or might plausibly raise, similar arguments. In its bond litigation against Russia, Ukraine argued (and lost) that the $3 billion Russian bond issue violated Ukrainian law. Likewise, at least some portion of Venezuela’s outstanding debt—especially loans incurred by the Maduro government—might plausibly be challenged by a successor government as illegal under Venezuelan law (see here and here).

One argument for allowing governments to avoid loans without paying restitution is that investors in these types of instruments are sufficiently informed to evaluate a loan’s legality. Put differently, and in terms that echo the Restatement (Second) of Contracts: investors are neither “excusably ignorant” of the debt limit violation nor less culpable than the government. Of course, the lawyers for the underwriters will issue an opinion letter affirming the legality of the deal, but investors are capable of conducting their own evaluation. Or perhaps investors should focus their ire on bond counsel instead (as the previously-linked note in the NC Banking Institution discusses at pp. 214-15).

To be sure, sovereign debt practice (and maybe law) generally does not let a government avoid debts incurred by a predecessor, even when the debt is odious or illegitimate. A case that comes to mind is Republic of Iraq v. ABB et al., 768 F.3d 145 (2d Cir. 2014). Oversimplifying, the post-Saddam government of Iraq was trying to disclaim responsibility for the previous government’s involvement in corrupt transactions. The Second Circuit, however, refused to draw a distinction: “where a plaintiff in Iraq’s position bears fault, it does not escape the consequence of its wrongdoing on the basis of a change in leadership.” The objectors’ argument, however, is not predicated on a distinction between the government that incurred the debt and the government that now wants to avoid it. It argues that the loan was, and remains, illegal. That argument also heads off any claim that the Puerto Rican government subsequently ratified the loan by continuing to make coupon payments. An illegal contract can’t be ratified unless the circumstances making it illegal have been removed.

If the Control Board wins, it is an interesting question how the market will react. Needless to say, there has been much discussion in the financial press (see here, here, here and here). Unsurprisingly, some market participants are outraged and predict that the sky will fall and that Puerto Rico’s borrowing costs will increase dramatically.

Maybe; maybe not. Let’s assume part of Puerto Rico’s debt was illegally issued. Will the market penalize Puerto Rico for retroactively policing this illegality? This strikes us as an empirical question without an obvious answer. The economic logic behind constitutional debt limits and balanced budget rules is that such commitments help ensure fiscal prudence, which should reassure investors and protect the borrower’s citizens and residents from the costs of excessive debt. But these benefits require that the commitment to fiscal prudence be credible, and that requires institutions capable of enforcing discipline. (There is of course an important literature on this subject, including foundational work like Douglas North and Barry Weingast’s Constitutions and Commitments.) Allowing the government to avoid illegal loans ex post might create positive incentives. Perhaps the bankers who engineer these deals, and the lawyers who write comfort letters, will police transactions more carefully in the future. If so, investors may view the Commonwealth’s commitment to fiscal prudence as more credible, and borrowing costs might go down. Ultimately it’s an empirical question. For example, one might ask whether yields on Puerto Rico’s other, legally issued, debt are increasing thanks to this case (correcting, of course, for the effect of the reduction to the debt stock).

Bottom line: This is going to be a fascinating case with big implications in the future.


What representations did the Issuer make in the purchase agreements, who issued Issuer's legal opinions for the offering, what did those opinions say, and what (if any) estoppel arguments are created thereby?

Important to note that Jim Millstein, Cleary Gottlieb and Proskauer (OBoard's current counsel) were all retained by the PR GDB in the months leading up to the March 2014 GO deal in addition to 14 underwriters, bond counsels etc.

How do we explain the presence of all these world class debt restructuring guys as their client zoomed past their constitutional debt limit?

Big implications for the future indeed!!

If Puerto Rico is successful in this endeavor (which it looks like it very well may be), will this be a new tool in the toolbox for countries who are "unwilling" to pay their debts? We have seen countries, like Argentina, who are essentially in a stand-off with certain creditors. It seems possible that constitutional debt limits may be an escape hatch from these games of chicken. I'm curious if/how PROMESA influences how this plays out or if Puerto Rico's experience here will be replicable across the globe. If Puerto Rico's bankruptcy had been a Chapter 9 (if the law permitted, obviously), would things be different?

I think perhaps the biggest issue, alluded to at the outset of the last paragraph, ultimately is one of reputation. The debt in question here represents less than 10% of Puerto Rican bonds. But with no lifeline likely from Congress any time soon and ever-expanding pension liabilities on the horizon, Puerto Rico is going to be dipping into the bond markets again sooner than later. While true Puerto Rico may not end up paying now—the markets very well may make them pay later, and it seems unlikely investors will be quick to forgive this attempted sleight of hand. Ultimately it feels as though Puerto Rico is making a big play over smaller stakes than necessary—and could pay later because it.

I can see how doctrinally the bondholders (mostly sophisticated institutional investors - http://www.cadtm.org/Who-Owns-Puerto-Rico-s-Debt-Exactly-We-ve-Tracked-Down-10-of-the-Biggest) would have a hard time asserting that they were ignorant. But I wonder if they could dispute the numbers by questioning the math behind the Control Board's argument (esp. given the lack of transparency in PR gov accounting - https://www.nytimes.com/2018/12/19/business/puerto-rico-bankruptcy-promesa-mckinsey.html).

Although I think the litigation would make a good textbook example of contract principles, the amount in dispute is pretty small compared to the total amount of debt that PR owes, and bondholders are probably going to litigate some procedural, accounting, or evidentiary points and drag the litigation on. The island is already in deep financial trouble (in addition to the debt, the bankruptcy, the natural disasters, and the shutdown); I doubt this litigation does more good than harm.

I have difficulty believing an argument that the Commonwealth or the sophisticated institutional investors with whom it contracted were ignorant of the debt limit at the time that these bonds were issued. My gut instinct here is backed up by Stephen Lubben's observation that the GO bond contracts mentioned future debt cap issues as one of the identified risk factors (https://www.creditslips.org/creditslips/2019/01/the-commonwealth-and-the-gos-part-1.html). In my opinion, PR’s situation would be more believable under a theory of failure of a basic assumption through mutual mistake, rather than the incompetence argument that the Control Board is making.

Given the lack of transparency in PR government accounting that Nick mentioned (in a previous comment here), it seems to me that it would be possible that, at the time of the bond issuance, both sides made a mistake as to a basic assumption upon which the contract was made - that is, whether or not these bonds made PR to exceed its constitutional debt limit. In such a circumstance, Restatement 152 says that the contract would be voidable unless it allocated the risk to the "affected party." It seems to me that the Commonwealth is avoiding this (perhaps more believable) argument due to the risk that a court would assign the risk of loss to them, rather than to the investors, which would undercut their argument against restitution.

Another dimension is that up to $400 million of the 2014 $3.5 billion GO deal was done to take out liquidity facilities and terminate swaps that underwriters had.

See page 24 of the OS "Transactions with Underwriters"

"Barclays Bank PLC, the parent company of Barclays Capital Inc., which is acting as representative of the Underwriters, has issued a letter of credit to the Commonwealth providing credit and liquidity support for approximately $188.7 million of the Refunded Bonds. Barclays Capital Inc. also was the original purchaser of the COFINA BANs and Barclays Bank PLC and its affiliates and subsidiaries have credit exposure to such notes, which notes will be repaid with a portion of the proceeds
of the Bonds.

The Commonwealth will use Bond proceeds to make termination payments, either directly or indirectly by reimbursing GDB for amounts borrowed under certain lines of credit the proceeds of which were previously utilized to make a termination payment, on interest rate exchange agreements with Morgan Stanley Capital Services LLC, FMS Wertmanagement AöR, The Bank of New York Mellon, and Merrill Lynch Capital Services, Inc. Morgan Stanley Capital Services LLC and Merrill Lynch Capital Services, Inc., are affiliated entities of Morgan Stanley and BofA Merrill Lynch, respectively, underwriters of the Bonds.

The aggregate amount of the termination payments is approximately $90.16 million, of which Merrill Lynch Capital Services, Inc. and Morgan Stanley Capital Services LLC will receive approximately $13.1 million and $24 million, respectively. After the termination of all of these interest rate exchange agreements, the Commonwealth will have approximately $126.7 million of Variable Rate GOs outstanding as to which it has not mitigated against increases in the rates of interest (for which any increase in interest rates is tied to the consumer price index). In addition, after the termination of these interest rate exchange agreements, the basis swap with Goldman Sachs Bank USA will be the Commonwealth’s only remaining interest rate exchange agreement outstanding.

J.P. Morgan Chase Bank, National Association, an affiliate of an underwriter of the Bonds, has provided a liquidity facility for approximately $14.9 million in aggregate principal amount of the Refunded Bonds. J.P. Morgan Chase Bank, National Association, also holds approximately $59.8 million in aggregate principal amount of the Refunded Bonds that will be repaid with a portion of the proceeds of
the Bonds.

Banco Santander Puerto Rico, an affiliate of Santander Securities LLC, an underwriter of the Bonds, and Oriental Bank, an affiliate of Oriental Financial Services, an underwriter of the Bonds, each holds approximately $98.7 million in aggregate principal amount of the Refunded Bonds that will be repaid with a portion of the proceeds of the Bonds.


So who told what to underwriters? It's likely that underwriters will claim that the issuer made false representations to them regarding the constitutional debt limit.

Also note that MSRB, who oversees the muni market, has explicit rule against fraudulent dealing with issuers (Rule G-17) http://www.msrb.org/Rules-and-Interpretations/MSRB-Rules/General/Rule-G-17.aspx?tab=2 so dealers will likely be attacking each other too as part of the avoidance litigation.

JP Morgan Chase, at least, should have been wary of this sort of thing, since as Chemical Bank in the early 1980's it was the big-loser plaintiff in the WPPSS default case (the "Whoops!" bonds), which involved the repudiation of government debt on the grounds that the municipalities which assumed it had acted ultra-vires:


Given the controversy surrounding the existence of the Control Board itself (https://www.npr.org/2018/08/08/636603584/judge-rules-in-favor-of-puerto-rico-oversight-boards-authority), it seems plausible that this decision will spur on more litigation about the validity of the Control Board and its decisions. Perhaps the Control Board will have to rethink its decision for political reasons if the threat of these lawsuits is too daunting.

Irrespective of whether the bondholders have a right to restitution, I agree with the comments above that this scenario does not provide appropriate incentive for Puerto Rico to file an objection. The risk/reward ratio is far too high, given the relatively low stakes and the reputational and potential administrative instability costs vis a vis the Board.

From a contract law perspective, the bondholders' relative sophistication makes them a ripe target for an objection. And I think this litigation could produce positive effects for the reasons the blog mentioned — particularly with respect to the bankers and lawyers — but the beneficiaries are more likely to be more prudent, future bond purchasers, passing along the costs to Puerto Rican citizens.

I also wonder if this action would embolden other regimes to capitalize on an increasingly cynical populace, portions of which may regard sovereign irresponsibility as less threatening than they might otherwise.

As many people have pointed out, it is questionable as to whether this is a smart strategy on Puerto Rico's part: is it worth it to hurt their reputation to have a small part of their loans voided when there is over $72B to deal with and future debts to consider. (Granted, the literature is conflicted with regards to whether reputation matters).

But I admit, I am confused -- my understanding is that Puerto Rico's debt was so high that it needed to come up with a sneaky way to void some of it, so it added on the Puerto Rico Public Buildings Authority's debt to thereby cross the Balanced Budget clause of their constitution. First, if that does not work, then Puerto Rico just added an additional debt it has to deal with immediately. Yet even if this strategy works now, it may have been unwise when you look at the long-term implication -- it then means that there is a significant risk that the PBA will be considered Puerto Rico's alter ego in future situations, and open up that big can of worms with regards to liability, unable to shield PBA's assets from Puerto Rico's bondholders and vice versa, etc. This goes directly against Puerto Rico's argument that PBA was NOT an alter ego. See Iravedra v. Public Building Authority, 196 F. Supp. 2d 104 (D.P.R. 2002) ("The Commonwealth alleges in its motion to dismiss that, pursuant to the organic act that created the PBA, it is impossible to conclude that this public corporation is an alter ego of the Commonwealth. Rather, it contends that, although the PBA is public corporation, it is nonetheless a separate and distinct legal entity.").

Next, I have to agree with a lot of the others: we should not be concerned about these bondholders. First, Stephen Lubben points out that the disclosures for the 2014 GO's included a warning to investors about the potential for the Balance Budget clause to be invoked if PBA's debt was included in Puerto Rico's debt. Granted, they are separate entities, but considering how intertwined they are with respect to the rent revenues and Puerto Rico guarantees, it does not seem that far fetched to say they are alter egos and thereby include the debt into Puerto Rico's overall balance. Moreover, Trump said we should "wipe" out Puerto Rico's debt -- meaning, bondholders should say "goodbye" to their investment, so there was a signal this may happen.

Finally, as callous as it may sound, I think this is simply the cost of doing business. Many of the investors that purchased these bonds were hedge funds: they wanted a high risk, high return investment, and that's what they got: a high risk investment that is now probably going to be voided. These are sophisticated parties that should have read the bonds carefully to understand their investments (i.e. read the disclosures carefully) with access to sophisticated lawyers, and if they or their lawyers did not, then with $6B in bonds voided, it will teach future parties that they should be more careful in the future, which ultimately makes the system better.

I'm somewhat skeptical of the argument that voiding this debt not requiring restitution would be a devastating blow to Puerto Rico's ability to raise money in the future. Theoretically, I suppose it should matter, but the instability in Puerto Rico's governing situation might give future leaders an opportunity to raise money on the idea that this epoch was a blip, an outlier. Some structural changes are probably in store anyway, which would help distance future regimes from this weird oversight board period.

As to the question of the debt itself, I feel this piece might not go far enough. Given the uniqueness of sovereign debt and the relationship between political figures as agents of governments and people, I would be happy to place the burden of investigation and loss avoidance on the investment banks, lawyers and lenders that agreed to an illegal bond. If we woke up tomorrow and the 8 billion was wiped away completely, perhaps the world sovereign lending would be more sustainable, less covert and filled with fewer instances of outright fraud.

Mark: Might PR also be able to claw back the interest payments that have already been made on this allegedly dodgy $6bn?

Though I agree that, proportionally to its total debt, the amount that Puerto Rico is seeking to invalidate is not particularly high, I am hesitant to dismiss the value in the objection for this reason. $6 billion dollars saved is still $6 billion dollars saved that can be used for the benefit of its people and for government services/programs.

Additionally, now that such an argument was introduced (regardless of its success), it is interesting to consider what implications this could have in the sovereign debt world. Seemingly, many sovereigns have disregarded debt limits before. Might Italy raise an analogical objection to reduce their debt stock? Might other countries as well?

I am also skeptical of the argument that voiding this debt would be a devastating blow to Puerto Rico's ability to raise future funds. A lot of people have questioned the wisdom of making this move in relation to Puerto Rico's reputation, but I think this is forgetting that the idea of reputation is more important in theory than in practice. Empirically, it is very unclear whether reputation really makes that much of a difference; there are many other factors involved, and a lot of times we see different administrations in the same country have different priorities when it comes to their sovereign debt (see Argentina under Kirchner versus under Macri).

While a government usually cannot be excused from its debt even when it is odious or illegitimate, I think this is a completely different case, and I agree that the Second Restatement seems more applicable. Like many have already mentioned, it makes sense for us to place the blame on investment banks, lawyers, and lenders because they were sophisticated parties and because voiding this debt could have a net benefit of encouraging parties to investigate the terms of their deal more closely. This is not a government trying to get rid of a debt that a previous administration took that the current administration just wants to cast off as illegitimate, but rather something that was illegal in the first place and never ratifiable.

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