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The Commonwealth and the GOs, part 1

posted by Stephen Lubben

While there has been some press coverage of the recent attempts to annul some $6 billion of Puerto Rican general obligation bonds – essentially all such debt issued starting in 2012 onward – the move has not received much deep coverage. Yesterday I took some time to read the claims objection filed in the Commonwealth's article III case, and in this post I'm going to consider the arguments against the bonds' validity. In a further post, I will consider what is going on here from a strategic perspective.

The objection was jointly filed by the creditors' committee and the Financial Oversight and Management Board for Puerto Rico, but the Board only joined in one of the two main arguments that are put forth. (There is a third argument in the objection – about OID and unmatured interest under section 502 fo the Code – that I'm not going to talk about because its rather pedestrian by comparison).

In sum, the committee argues that GO bonds issued in 2012 and 2014 violated two provisions of Puerto Rico's constitution, and thus the bonds should be deemed void. The Board joins in the objection with regard to the first constitutional provision, but not the second. If successful, this objection would eliminate $6 billion of the $13 billion in GO bonds currently outstanding.

More details after the break.

The Commonwealth's constitution contains two provisions of relevance. First, there is a limit on the amount of debt Puerto Rico can issue – essentially, anticipated debt service may not exceed 15% of average tax revenue over the prior two years. Second, there is a provision mandating balanced budgets. The committee argues that the 2012 and 2014 GOs put Puerto Rico in violation of both provisions, while the Board only joins in the argument with regard to the first provision.

Much turns on whether debt issued by the Puerto Rico Public Buildings Authority counts as debt issued by the Commonwealth itself. The objectors say "yes." They note that the PBA's debt was payable only with rents received from the various Puerto Rican government entities that used its buildings, and that the Commonwealth had backed up those rent payments with its own credit. Moreover, the Commonwealth also directly guaranteed the PBA's bonds.

In short, we have a basic substance over form argument, with the objectors arguing that once you take account of the PBA's outstanding debt, any GOs issued after March 2012 could not satisfy the constitutional requirements. There is a lot of caselaw in favor of the objectors, and the few cases going the other way (including cases from New Jersey) are distinguished on their facts. Namely, the objectors argue that Puerto Rico has backstopped the PBA's debt much more extensively than in those cases.

Now the obvious question is what do the bond documents say about all this – because it's hard to imagine anyone buying Puerto Rican debt if the disclosure document said "by the way, there is a chance your bonds might be unenforceable. Best of luck." At least, nobody would buy it without a pretty hearty coupon, and even then I would have to think that the '40 Act funds might have hesitated.

I took a look at the disclosures regarding the 2014 GOs, figuring that the issue would have been most salient with regard to the later debt. One identified risk factor is that the Commonwealth might run up against the debt cap in the future. There is also an oblique reference to the PBA issue in that the 2014 disclosure statement argues that the Commonwealth's guarantees do not count against the debt cap unless payment under the guarantees are actually trigged. That is, so long as the guarantees are contingent, we are good. And the 2014 statement expressly notes that Puerto Rico had backstopped some $6 billion in debt, about 2/3rds of which was PBA debt. It seems that this loose interpretation of the debt limit comes from an opinion issued by the Secretary of Justice of the Commonwealth, but the disclosure statement is a bit vague on that (see pages 10 and 11 in particular).

Let's assume that this argument is accepted by the court – that still leaves the question of Puerto Rico's direct obligation for the lease payments which are the primary source of payment of the PBA's debt. Here the references are quite opaque. For example, the 2014 disclosure statement notes that

General Fund total expenses for fiscal year 2012 amounted to $11.158 billion, consisting of $9.911 billion of operating expenditures, $331 million in rent payments to the PBA, and $915.9 million of other financing uses (mostly debt service).

As the objectors make clear, there is really no functional difference between the PBA rent payments and debt service, especially since the PBA rent payments were made to match the PBA debt service payments, and the Commonwealth had to make these payments one way or another. Is there any sense in saying that the constitutional cap can be evaded by running debt service payments through a conduit?

In short, the objectors' argument has legs. In my next post, I'll engage in some speculation about what might be going on here. And I hope that my more sovereignly inclined Slips colleagues will weigh in on this issue too.



There are a multitude of issues here and discovery on the invalidation motion has been scheduled and will likely uncover some very unpleasant facts.

Although I calculated in Feb 2014 (prior to the $3.5 billion GO issuance) that PR's last public debt deal would breach the constitutional debt limit http://blogs.reuters.com/muniland/2014/02/13/puerto-ricos-debt-limit/ the Puerto Rico Government Development Bank said publicly following the deal coming that they retained substantial debt capacity following the deal:

"The issue was upsized from $3.0 billion to $3.5 billion due to unprecedented demand; total orders,received from 270 different accounts, surpassed $16 billion, which represents more than four and a half times the bonds available for sale.

Notwithstanding the upsizing, the Commonwealth retains approximately $900 million in GO bond capacity under the constitutional debt limit, capacity which should materially expand during fiscal year 2015 if fiscal year 2014 revenues come in line with forecasts."


Lots of firms with global reputations advised on this deal in addition to 14 underwriters. How did everyone get it wrong?

First, each case cited involved _taxpayers_ challenging the *creation* of a third-party entity specifically created for the purpose of evading debt limits. In contrast, the Puerto Rico PBA was created in 1958 and was issuing bonds as far back as 1970 (of which $37.3 million still remains outstanding).

Second, the FOMB wants it both ways. In the 'claims objection,' the FOMB argues that the rent payments to the PBA effectively makes the PBA bonds "direct obligations of the Commonwealth" that should count towards the debt limit, but in the 'disallowance of rent objection,' the FOMB argues that "the Commonwealth is entitled to a declaration . . . that . . . the Debtors have no obligation to make [rent] payments to PBA."

Very interesting post! While reading this, I have to wonder whether it is worth it for Puerto Rico to embark on this strategy as it is only a small portion of their overall debt, and it seems like it opens up the possibility of the Puerto Rico Public Buildings Authority becoming declared an alter ego without Puerto Rico being able to credibly argue against that after this move. In the long-run (say an exchange offer in 20 years where Puerto Rico tries to hide assets from bondholders like what Venezuela could do with PDVSA), is it worth it?

I think it's interesting that back in 2002, Puerto Rico argued that PBA was a separate entity. "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. " Iravedra v. Public Building Authority, 196 F. Supp. 2d 104 (D.P.R. 2002).

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