Puerto Rico Title III bankruptcy Judge Laura Taylor Swain on Tuesday heard arguments on one of the key issues in the case: are the Puerto Rico Sales Tax Finance Corp. bonds legal?

At issue are $17.5 billion in bonds, referred to by the Spanish acronym COFINA. The parties were arguing about whether Puerto Rico’s government can use sales and use tax revenue pledged to the bonds to pay other forms of debt and for other purposes. Swain asked challenging questions of attorneys on both sides and didn't signal which way she was leaning.

Susheel Kirpalani, representing COFINA Senior bond holders, said that bankruptcy law encourages respecting local laws.

Tuesday’s hearing was a motion on summary judgment. Though the hearing may lead directly to a decision, it is possible that the judge will deny the motion and refrain from ruling until later in the Title III process. Alternately, on April 25 she will hear arguments on whether she should ask the Puerto Rico Supreme Court to rule on the central Puerto Rico constitutional issues concerning COFINA.

The local statute said that the pledged sales tax revenue would be COFINA’s property and that is key, attorney Antonio Yanez Jr. said, in representing COFINA.

Susheel Kirpalani, attorney for holders of COFINA Seniors bonds, asked if he went to a shop in Puerto Rico and paid for a good, why the sales tax portion of what he handed over should be considered as belonging to the Puerto Rico government, as the general obligation holders claim. Puerto Rico statute says the money belongs to COFINA, he said.

There is nothing idiosyncratic in the U.S. about a securitization like the COFINA bond structure, said Kirpalani, Chair of the Bankruptcy and Restructuring Division at Quinn Emanuel Urquhart & Sullivan. He said nothing in federal law preempts it. The Puerto Rico Oversight, Management, and Economic Stability Act encourages the judge to respect local laws, he said.

Kirpalani said that general bankruptcy law includes a presumption against ruling against state laws unless federal laws clearly overrule them.

Representing the Ad Hoc Group of General Obligation Holders, attorney Mark Stancil said Puerto Rico’s constitution makes the COFINA bonds illegal. Article 6 of the constitution says that the commonwealth’s debt has the first claim on available resources.

Because of this claim, the Puerto Rico legislature didn’t have the authority to transfer the sales and use tax revenues to COFINA, as it did in 2007, said Stancil. He said that articles 2, 7, and 8 of the constitution speaks of “available resources” and only the GO bondholders have provided a reasonable reading how this should be conceived.

“Available resources” means all revenues that came into the central government, he said. With COFINA, the legislature tried to avoid this.

COFINA was used as an “end run” around Puerto Rico's debt limit, said Stancil, partner with Robbins, Russell, Englert, Orseck, Untereiner & Sauber. He said other states have ruled against end runs around debt limits by their municipalities.

Stancil said that while the legislature had the authority to sell physical assets it didn’t have the authority to give away a revenue stream like the sales and use taxes.

Swain pointed out that those who bought GO bonds from Puerto Rico since 2007 have been given official statements that said the sales and use taxes going to COFINA wouldn’t be available. She asked Stancil for a response. He said that even those who bought after 2007 should have access to the sales and use tax revenues that came in after 2007, because the legislature didn’t have the power to evade the Puerto Rico constitution.

Attorney Luc Despins, representing the Committee for Unsecured Creditors, said in the Orange County, California, Chapter 9 municipal bankruptcy, the court said money that was held in trust by the county should be treated like all the other money in the case. These trusts were similar to COFINA, said Despins, partner at Paul Hastings.

Despins said that there were several times in COFINA OS’s that bond purchasers were warned that the legislature might end the sales and use tax and thus cut the money to COFINA. He said this supported his argument that the bondholders don’t own the revenues and that instead the Puerto Rico government owns them.

In rebuttal, Yanez said the GO Holders had set up a false starting point with Puerto Rico’s Article 6 clause on debt payment. The partner with Willkie Farr & Gallagher said that all of the GO holders’ arguments flow from there. A better starting point is the Puerto Rico constitution’s specification that the legislature had control over taxation.

Swain said she would take the case under advisement and noted that there would be a discussion of whether constitutional issues should be referred to the Puerto Rico Supreme Court at the April 25 hearing.

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