The Fiscal Agony of the Absence of Chapter 9

eBlog

Good Morning! In this a.m.’s eBlog, we consider the growing physical and fiscal breakdown in the U.S. Territory of Puerto Rico as it seeks, along with the oversight PROMESA Board, an alternative to municipal bankruptcy.

Tropical Fiscal Typhoon. With the expiration of the freeze on litigation against the U.S. territory of Puerto Rico expiring yesterday, municipal bondholders filed suit against the Puerto Rico, likely marking the front end of a number of suits in the wake of Puerto Rico’s under the PROMESA law after its default on $1.3 billion of principal owed since the previous Governor declared the $70 billion public debt load unpayable in June of 2015. Bondholders filed two new lawsuits, even as the stay was lifted from at least 13 others. In the suits, the plaintiffs are seeking 11 declaratory judgments, two writs of mandamus, and three permanent injunctions. The fiscal meltdown came against a wavering political backdrop, as a demonstration in Puerto Rico’s capital, San Juan, against the PROMESA board’s austerity measures Monday turned violent: there was extensive damage to a Banco Popular office building’s windows, fires being lit, and car windows being smashed. The newest suits come after the administration of Gov. Ricardo Rosselló was unable to negotiate any agreement with the territory’s municipal bondholders after the May 1st deadline of the litigation freeze. His Chief of Staff, William Villafane, told the AP just hours before the freeze expired that the government preferred to reach a deal with bondholders, adding, however, that a municipal bankruptcy-like process could be an option if negotiations were to fail. A group representing those who bought a portion of the $16 billion worth of municipal bonds backed by Puerto Rico’s sales tax, charged that the government plan to cut its $70 billion debt was unconstitutional; they accused government leaders of perpetrating “unfair, unjust, and illegally punitive terms.” Ambac Assurance Corp. filed its own suit, accusing the government of illegally retaining $300 million owed to bondholders. The suit alleges it had been forced to pay more than $52 million in insurance claims because of ongoing defaults by Puerto Rico’s government. The tropical storm of litigation, coming on top of nearly a dozen lawsuits prior to the freeze imposed under the PROMESA law, came as Aurelius Capital Management LP, and other hedge funds, sued Puerto Rico in New York state court, seeking to recoup past-due payments on some $1.4 billion in defaulted general obligation bonds.

The precipitous storm of litigation appeared to mark the collapse of restructuring negotiations, as well as to signal the PROMESA board will vote to trigger the PROMESA Title III provisions to trigger a quasi-chapter 9 municipal bankruptcy proceeding. The fiscal disruption, at the same time, appeared to come as a physical disruption of riots and active lawsuits, leading the Dean of chapter 9 municipal bankruptcy, Jim Spiotto, to note: “Sometimes it is darkest before the dawn.” Counselor Spiotto added that a “litigation meltdown is not a solution” to the Puerto Rico debt problem; rather, he added: “You may have all the rights in the world, but if the [debtor] party doesn’t survive, thrive, your ability to get repaid is severely diminished,” noting that litigation is the least likely means of reaching a long-term solution, since the debtor is going to be hit by substantial attorney’s fees. Further, he explained, even were the PROMESA Oversight Board to initiate Title III to consolidate all Puerto Rico debt cases into a single quasi-bankruptcy process, that would simply open the way to a long and costly trail of appeals; thus, he notes that instead, all parties need a “time out” if there is to be a realistic chance of a fiscal solution, noting that would almost surely lead to a better outcome for all parties. Or, as U.S. Rep. Nydia Velázquez (D.-NY.) put it: “The power to comprehensively restructure 100 per cent of Puerto Rico’s debt is the reason why I voted ‘yes’ on [PROMESA] last year….Inconceivably, today, May 2, 2017, the island is on the same path as it was prior to the enactment of the law. This is unconscionable. It is imperative the board use this powerful tool and vote to file for a Title III proceeding immediately.”

The fiscal collapse also creates a constitutional and governance crisis. Article VI of Puerto Rico’s constitution (§8) provides that: “In case the available revenues including surplus for any fiscal year are insufficient to meet the appropriations made for that year, interest on the public debt and amortization thereof shall first be paid, and other disbursements shall thereafter be made in accordance with the order of priorities established by law;” however, Title III of the federal PROMESA statute would supersede this.

The growing challenge spread also, as Ambac filed suit against the U.S. Treasury Secretary Steven Mnuchin, seeking to bar access by the U.S. territory to a federal excise tax imposed on rum manufactured in the territory and sold in the mainland U.S. Moreover, Ambac also filed two other lawsuits over Puerto Rico’s alleged efforts to break the lien securing some $17 billion in sales-tax municipal bonds—one suit in federal court, the other in New York state court. One, in federal court, sought a court order safeguarding the revenue stream that backs those bonds.

Amid the various court challenges, Gerardo Portela, the Executive Director of Puerto Rico’s Financial Advisory and Tax Agency, yesterday claimed: “We are talking to all the different groups of bondholders,” after leaving La Fortaleza after holding a meeting with Governor Rosselló. Moreover, with the increasing threat to critical public services, Puerto Rico Property Secretary Raul Maldonado yesterday provided assurances that the government already has part of the money required by the Fiscal Supervision Board to avoid the reduction of working hours in public employees.

Just to provide some scale of what is unfolding, the quasi chapter 9 municipal bankruptcy here under a federal court-supervised restructuring for a portion of Puerto Rico’s $70 billion debt would be 800% larger than Detroit’s—which to date, has marked the largest chapter 9 bankruptcy in American history. However, with Puerto Rico neither a municipality, nor a state, it falls into a legal and fiscal Twilight Zone. In the wake of bondholder rejection, over the weekend, of an offer to pay 50 cents on the dollar to holders of Puerto Rico general obligation and sales-tax bonds backed by Puerto Rico’s constitution, it increasingly appears a non-federal bankruptcy court will be pressed to try to put Humpty Dumpty back together again.

Meanwhile, in Congress, federal legislation, HR 1366, the U.S. Territories Investor Protection Act of 2017, a bill to try to close a legal loophole which some in Congress believe allowed broker-dealers to defraud Puerto Rico investors was passed on a voice vote by the House and will now move to the Senate for consideration. The legislation would extend all the rules under the Investment Company Act of 1940, which apply, to investment companies on the U.S. mainland to those investment companies operating in Puerto Rico and the other U.S. territories. Rep. Velázquez, in introducing the bill, noted: “Today’s bipartisan action in the House is a huge step for the people of Puerto Rico, and I will keep applying pressure for Senate action.” A companion bill in the Senate (S. 484), sponsored by Sen. Robert Menendez, D-N.J., has already cleared the Senate Banking Committee. The Congresswoman said that the legislators had “acted in the best interest of retirees and individual investors in Puerto Rico,” adding that: “For far too long, Puerto Rican retirees and others have been preyed on by unscrupulous investors who have exploited this disparity in the rules…By passing this measure in the House, we are one step closer to putting an end to these abuses.”

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