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In this morning’s eBlog, we consider a critical audit commission report released yesterday in Puerto Rico: a report which could have significant implications for Congress when it takes up HR 4900, the Committee on Natural Resources Puerto Rico Oversight, Management, and Economic Stability Act or PROMESA, as early as next week, as well as passage last night in the Michigan House of legislation to address the Detroit Public Schools’ looming insolvency: ironically both DPS and Puerto Rico confront July 1 deadlines.
Scooping & Tossing. The Puerto Rico Public Credit Comprehensive Audit Commission, a government-appointed commission made up of 17 members, including elected officials, representatives of the financial institutions, credit unions, academics and organized labor, in an audit published yesterday, suggests that much of the territory’s debt may have been sold illegally—and that Puerto Rico may be able to void some of its borrowing repayment obligations because politicians exceeded constitutional debt limits and their own authority: that is, potentially the finding would permit the government to declare the tax-exempt bonds invalid and courts to then decide that creditors’ claims are unenforceable. The scope of the audit report covers the two most recent full-faith-and-credit debt issues of the Commonwealth: Puerto Rico’s 2014 $3.5 billion general-obligation bond offering and a $900 million issuance in 2015 of Tax Refund Anticipation Notes to a syndicate of banks led by J.P Morgan. The report’s conclusions may allow the Commonwealth to pursue a strategy with even more dire consequences for the island’s municipal bondholders: the report says that Puerto Rico may have violated its constitution by borrowing to finance deficits, borrowing beyond its debt ceiling and using a refinancing technique called the “scoop and toss” to effectively exceed bond-duration limits.
Funds to meet these debt obligations are not in the Commonwealth’s proposed budget: this Tuesday, Gov. Alejandro García Padilla, sent a proposed FY2017 budget to the island’s legislature that provides for only $209 million of the $ 1.4 billion of current debt-service cost. As Gov. Padilla told reporters at a news conference: “This is simple: either we pay Wall Street or we pay Puerto Ricans. If the legislature decides we pay Wall Street more, well, each has his responsibility. I will continue defending Puerto Ricans. Money I send to Wall Street, I do not have to provide services here.”
Puerto Rico defaulted May 1 on a portion of its $72 billion in outstanding debt, but the commission’s audit covers two debt issues expected to default on July 1.
The Puerto Rican constitution contains a balanced-budget clause that explicitly prohibits borrowing to finance operating deficits, but its politicians borrowed to cover deficit financing in its 2014 General Obligation Bond Offering, according to the commission’s initial review. The March 2014 General Obligation Bond states that the proceeds would be used in part to cover deficits that had accumulated and that were expected to occur in the year of the offering. The documents include a chart showing deficits financed with borrowing during the past and that were expected to recur. In addition, Puerto Rico did not inform its bondholders that its constitution forbids it from using debt to finance deficits. That, the Commission’s report suggests would constitute “substantive” noncompliance with the letter of the Constitution.
The U.S. Supreme Court has said in the Litchfield v. Ballou case and, more recently, in litigation related to Detroit’s bankruptcy that borrowing above a debt ceiling may allow the issuer to declare debt invalid and, therefore, unpayable. Detroit, in its plan of debt adjustment, sought to invalidate $1.45 billion in COPs (certificates of participation), debt issued by two shell companies called “service corporations.” The parties settled before the case went to trial, but, while refusing two initial proposed settlements, U.S. (now retired) Bankruptcy Judge Steven Rhodes determined that Detroit’s argument had “substantial merit” and that the suit would have had a “reasonable likelihood of success.” According to Melissa B. Jacoby, a professor of law at the University of North Carolina who specializes in distressed debt, negotiations have been complicated by claims that certain tax-exempt bonds are special and have priority over debt held by other creditors. She states: “But if some debt was issued illegally, then, at the very least, those creditors’ claims of priority are dramatically weakened: Indeed, they would be lucky to get anything at all.”
The commission itself is a creature set up two years ago, with yesterday’s report its first step in the commission’s work output: it includes many of the most powerful members of the Puerto Rico legislature; it also included Melba Acosta Febo, president of the Government Development Bank for Puerto Rico, several prominent Puerto Rican economists, accountants, business leaders, and one union official. In its report, the commission suggests that Puerto Rico’s selling of bonds going back to 1979 may have illegally broken the Puerto Rican constitution’s requirement for a balanced budget. The consequence of this may be that a court may bar it from borrowing in the future to finance operating deficits: the Commonwealth may be forced to raise taxes, or “declare the debt unpayable for lack of authorization.” (Puerto Rico’s constitution states that it cannot spend more than 15% of “internal revenues” in its Treasury on GO debt. Depending on definitions, it may be exceeding this level, according to the commission.) The report also finds that the constitution’s prohibition against issuing debt with more than 30 year maturities may have been broken through the sale of refunding bonds, and it questions whether the commonwealth and its advisors and underwriters complied with SEC Rule 15c(2)-12, which bars the sale of debt when an issuer is not disclosing financial information in a reasonable and timely manner.
Howard Cure, Director of municipal research at Evercore Wealth Management yesterday noted: “It seems as if this commission is trying to re-write history by questioning the commonwealth’s ability and authorization to have entered into many of their recent debt agreements…The idea of requiring a balanced budget is somewhat spurious since most states, as well as the commonwealth, don’t distinguish between a balanced budget on a cash or an accrual basis. Since most states look at their budget on a cash basis, there have been various gimmicks to balance operations such as deferring salaries or leasing back facilities. States such as California and Connecticut have also deficit financed their operations at various points in time…Questioning the actual authority to have entered into these debt issuances seems dubious.”
Focusing on Not Leaving a City’s Children Behind. Michigan House Speaker Kevin Cotter (R-Mount Pleasant) yesterday, in the wake of House passage of a legislative package by which Michigan would help pay off Detroit Public Schools’ (DPS) crippling debt and provide more transition aid under a $617 million rescue plan, described the marathon outcome as a “a plan put forward to save education in Detroit, not just an entity…and at the same time avoid what would be a disastrous [municipal] bankruptcy.” What’s not included in the adopted House plan is a Detroit Education Commission that would have authority over some charter and public schools, especially where the schools are located in the city.
In this set of bills, an advisory council will produce non-binding reports on where schools and transportation are needed in the city. Of the $150 million in transition costs, only $25 million can be used for maintenance and improvements in the district’s deteriorating school buildings. The rest of the money can be used for items such as teachers, vendors, financial services, human resources, cash flow needs, and improvements to technology in the new school district. The legislation also includes anti-strike language with substantial fines for teachers, administrators and school board members in response to sick-outs staged by Detroit teachers earlier this year to bring attention to the horrible conditions in the schools and the prospect of payless paydays.
Final legislative action and the Governor’s signature on some plan is key before DPS runs out of cash on June 30th. Earlier yesterday, Michigan Governor Rick Snyder, speaking at the Mackinac Policy Conference, had warned that a lack of financial stability in DPS this summer could cause more students to leave the school system, which has seen its enrollment plunge from 150,000 students a decade ago to about 46,000 this spring.
The key House action came on a 55-53 vote in the wake of intense talks between legislative leaders and Gov. Snyder: that bill would call for school board elections in November, but does not include a Senate-approved education commission, backed by Gov. Snyder and described as a critical priority by Detroit Mayor Mike Duggan—because of its vital role in determining where traditional and charter schools could locate in the city. Now the six-bill package heads to the Republican-controlled Senate, where it faces its own tests and final exam as early as next week. During House debate, Speaker Cotter said the compromise plan achieves the twin goals of returning the district to local control and relieving district debt, which would free up more money for classrooms, while key sponsor Rep. Daniela Garcia (R-Holland) added the bills will free up money that can go back into Detroit classrooms and provide oversight to taxpayers in other parts of the state.
For his part, Gov. Snyder embraced the House package despite its omission of the commission, calling it “a good step toward a compromise that sets in motion positive progress for the families of Detroit to have a sustainable and successful educational system.” As adopted, the amended House package includes $150 million in transition aid to restore academic programs and fix school buildings. Instead of the commission, vehemently opposed by the charter school lobby, the legislation would provide for an advisory council to produce reports highlighting where schools are needed and study a potential city-wide transportation system to serve all students. The six-member council would include district officials and charter representatives. Poor-performing traditional public or charter schools could be closed under the legislation, which would require the School Reform Office to develop an A-F letter grade system to evaluate schools. Three years with a failing grades would prompt closure. A state-appointed transition manager would run the new debt-free Detroit district until the elected school board took over in January. The manager could appoint an interim superintendent and adopt an initial budget. As passed by the House, the bill would effectively end the governor’s Education Achievement Authority, requiring the new district to withdraw from the inter-local agreement that facilitated its creation. The school board would appoint a new superintendent, but would need approval from Detroit’s Financial Review Commission to hire a CFO, fire a superintendent, or fund out-of-state travel for board members or district officials. The final legislative package includes several reforms previously approved by the House, including: increased penalties for teacher “sickouts,” merit pay, and the option for the school board to hire non-certified teachers to fill vacancies. The House plan differs from a plan passed by the Senate in March that included the DEC, which would be appointed by the Detroit Mayor and have authority over some of the charter and public schools.