The Puerto Rico Oversight Board's move to declare null $6 billion of general obligation bonds may itself be illegal, according to two attorneys following the case.
Last month's bid by the the board and unsecured creditors committee to vacate the bonds issued in 2012 and 2014 ran into opposition from U.S. bankruptcy specialist James Spiotto and John Mudd, a Puerto Rico attorney who represents a municipality in the territory's bankruptcy proceedings. Even if one accepts the argument that Puerto Rico's constitution made the 2012 and 2014 bond bond sales illegal, they argue that both federal and local law would bar nullifying them.
The Puerto Rico Oversight Board and the Unsecured Creditors Committee filed their motion on Jan. 14 in the Puerto Rico Title III bankruptcy court. They argued that the two 2012 GO bonds and one 2014 GO bond should be declared void because the bonds were sold in contravention to the Puerto Rico’s Constitution's debt limit and balanced budget clause.
The Puerto Rico constitution says that the government can’t incur additional debt if the resulting debt payments in any future fiscal year plus the debt payment for the prior fiscal year divided by the average annual general revenues of Puerto Rico for the two preceding fiscal years would be greater than 15%.
The Official Statement for the 2014 Puerto Rico GO bond said that after the bond was sold, the relevant percentage would be 14.2%.
Among other arguments, the board and the UCC argued that Puerto Rico was above the 15% threshold when all three of the bonds were sold because the Public Building Authority debt should have been treated as Puerto Rico government debt. The government paid the rent to the authority, which provided the revenue for bond repayment.
The board and UCC said in their motion that courts have generally seen building authority debt as part of central government debt, regardless of attempts by governments to treat it otherwise. They noted that Puerto Rico guaranteed not only its rent payments but also the PBA bonds themselves and thus the PBA debt should be considered part of Puerto Rico central government’s debt.
If one accepts this, the 2012 and 2014 GO bonds individually and collectively pushed Puerto Rico above the constitution’s 15% limit. The board and UCC argued that the GO bonds were illegally issued and thus should be considered null.
The board and UCC also argued that the local constitution bars the government from spending more than it has coming in for revenues. “Deficit financing is constitutionally prohibited and, because they were used to finance deficit spending, the Invalid GO Bonds were not issued for a lawful purpose,” they said.
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Spiotto cited Commissioners of Knox County v. Aspinwall, an 1858 ruling against a county in Indiana. In 1850 the county board had sold a bond to support purchases of railroad stock. In 1856 and 1857 the county stopped paying the bond. The board claimed it wasn’t responsible for paying the bond because its issuance hadn’t complied with the Indiana statute that had authorized the bonds. Specifically, the county board said it had failed to provide notices of the election that approved the bond.
The Supreme Court majority ruled in an 8-to-1 decision written by Justice Samuel Nelson that it was the county board’s responsibility to be sure that procedures around the bond sale were legal. “After the authority has been executed, the stock subscribed, and the bonds issued and in the hands of the innocent holders, it would be too late, even in a direct proceeding, to call [the circumstances leading to the bond] in question.”
The physical bond told the bearer that it had been issued by the county board of commissioners consistently with the relevant act of the Indiana General Assembly. “The purchaser was not bound to look further for evidence of a compliance with the conditions to the grant of the power,” the court justices said.
In the U.S. Supreme Court’s 1875 decision Marcy v. Township of Oswego, the justices addressed a situation even closer to Puerto Rico’s case.
After selling the bonds for Oswego Township, the Labette County board of commissioners tried to get out of paying the bond by saying that the bond was illegal because according to state law the township’s property value was inadequate to support the bond.
In a 6-to-3 decision, the justices found that “in a suit brought on some of the coupons by a bona fide holder for value, it cannot be shown as a defense to a recovery, that at the time of voting and issuing the bonds, the value of the taxable property of the township was not in amount sufficient to authorize the voting and issuing of the whole series of them.”
The justices pointed out that it was the responsibility of the county board to determine if the legal conditions were present for the bond to be sold. The justices pointed out that the physical bonds said they were sold in accordance with state law.
Spiotto said that in the late 19th century, “The High Court and many federal courts consistently supported bondholder rights in cases, like the current Puerto Rico dalliance with unwillingness to pay, when municipalities and state supreme courts attempted to invalidate/repudiate debt issued to good faith bond purchasers for good value provided to the government and the bond purchaser relied on the representation of the government issuer that all requirements for the valid issuance of the debt had been fully complied with prior to issuance.” Spiotto cited two additional 1875 Supreme Court decisions.
Responding to Spiotto’s argument, a spokesperson for the Puerto Rico Oversight Board said, “The Special Claims Committee of the Financial Oversight and Management Board for Puerto Rico believes there is no valid opposition to its objection to more than $6 billion of Puerto Rico’s bonded debt because the debt limit protections under the Puerto Rico Constitution protect an important public policy.”
In his Jan. 22, 2019, Control Board Watch blog, Puerto Rico attorney John Mudd used a different legal argument against the Oversight Board and Unsecured Creditor’s position that illegally issued bonds should not be paid. First, he said “I fail to see the federal issues in this challenge,” which has been filed in the federal court for Puerto Rico.
“Moreover, I disagree with the claim that Puerto Rico would not have to pay a penny if the 2012 and 2014 [bonds] were illegally issued,” Mudd continued. “Article 1247 of the Puerto Rico Civil Code, section 3496, which I believe is applicable here, states the parties have to give back what they received in the transaction, but the debt would not be bond debt pursuant to Article VI, section 8 of the Puerto Rico Constitution.”
The relevant civil code says in Spanish: “Cancellation [of a contract] obliges the return of the things which were the objects of the contract, with their fruits and the price with interest; consequently, it can only be carried out when the one who intended it can return what he was obliged to do . … Neither shall cancellation take place when the things which are the object of the contract are legally in the possession of third persons who have not acted in bad faith. In such cases the compensation for damages may be claimed from the person who caused the injury.”
A lawyer for Unsecured Creditors Committee didn’t respond to a request for a comment.
