Puerto Rico Board makes 'highly unusual' move to invalidate $6 billion of GO bonds

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The Puerto Rico Oversight Board filed an objection to invalidate $6.2 billion in general obligation bonds issued since the start of 2012, saying it it exceeded a territorial constitutional debt limit.

The board filed its objection late on Monday in the Title III case, challenging the validity of the 2012A, 2012B, and 2014 GO bonds. “The objection asserts that the invalid debt was issued in clear violation of the Puerto Rico constitution and should be declared null and void,” the board said in a press statement.

Carol O'Cleareacain and James Spiotto at a conference

The board said this was its “first major action” to result from a debt investigation report it commissioned. The Kobre & Kim report was released in August 2018. Since then four board members have constituted a “Special Claims Committee” to look into potential claims.

The board filed its objection in conjunction with Unsecured Creditors Committee. This represents non-bondholding creditors to the Puerto Rico government, like suppliers who haven’t been paid.

The board and the committee argue that the bonds exceeded the commonwealth’s constitutional debt limit. Additionally, the committee argues that the bonds were illegal because, contrary to the constitution, their proceeds were used to finance deficit spending.

The board’s action was “highly unusual,” according to U.S. municipal bankruptcy expert James Spiotto, who said he couldn’t think of an instance where an issuer tried to first declare a general obligation bond issuance legally invalid and then not to pay it.

From 1968 to 1971 the West Virginia Building Commission issued bonds it subsequently believed to be illegal. But it quickly turned to refinance with an alternate bond with a different revenue source, Spiotto said.

Spiotto said that he believed the board’s action was connected with the apparent imminent end to the Puerto Rico Sales Tax Financing Corp. (COFINA) bond adjustment process, as the Title III bankruptcy judge is scheduled to hold a hearing on the plan of adjustment on Wednesday. With COFINA process ending, the board is turning its attention to the next biggest amount of Puerto Rico debt outstanding. the GO debt, which had $13.3 billion outstanding as of January 2017.

“I think this is posturing,” said Spiotto, managing director at Chapman Strategic Advisors. The motion to invalidate GO debt issued since the start of 2012 is “part of negotiations and the kabuki theater of negotiations."

Spiotto noted that in the Detroit bond bankruptcy the emergency manager challenged the legality of the certificates of participation before a deal was reached to pay them, albeit at a steep discount.

Spiotto said there is the doctrine of latches in U.S. law whereby if an unreasonable period of time has passed to pursue a legal remedy the court will decline to enforce the remedy. “This will be a heavily fought case if not settled,” he said.

Puerto Rico attorney John Mudd said in an email, “It is going to be an interesting lawsuit ... and complicated.”

Howard Cure, director of municipal bond research at Evercore, said, “Holders of these potentially invalid bonds will undoubtedly contest this rigorously and could significantly slow down the COFINA settlement. These holders could question whether the COFINA bonds were structured to also circumvent various debt limits. Ultimately, the judge still needs to decide which security has the highest claim to the government’s cash and if she could subdivide the general obligation debt pre- and post-debt limits.”

The move will create ill will towards Puerto Rico in the investor community, Spiotto said. The Puerto Rican government may be seen like those of Ecuador, Argentina, and Brazil, which have once or repeatedly renounced their debts.

Assured Guaranty Head of Investor Relations and Communications Robert Tucker said that Assured Guaranty Municipal Corp. insured $369 million of the 2012A bonds. “The commonwealth’s Series 2012 A GO Bonds insured by Assured Guaranty Municipal Corp. were issued in full compliance with applicable provisions of the Puerto Rico constitution and related laws, including the constitutional debt limitation provision, and we believe that they are legal, valid, and binding obligations of the commonwealth.

“This objection is another example of the Oversight Board continuing to spend hundreds of millions of dollars on litigation and related expenses that run counter to the Oversight Board’s specifically legislated purpose: to achieve fiscal responsibility and capital markets access. Once again, the Oversight Board is more willing to disrespect the rule of law and litigate rather than engage in meaningful negotiations to develop a realistic solution to the Commonwealth’s fiscal crisis.”

Hedge Clippers, a group working against the interest of hedge funds, released a statement that said in part: “The Fiscal Control Board finally acknowledges what we have been saying for years, that the debt is illegal and shouldn’t be paid. However, despite this stance, ‘La Junta,’ the board, contradicts itself in the case of COFINA: another debt to which Puerto Ricans will be forced to pay in the next 40 years.”

In Tuesday trading through early afternoon the Municipal Securities Rule Board’s EMMA website, the 2014 GO bond was mostly trading between 47.8 cents and 49 cents on the dollar in block trades, down about 6 cents on the dollar from Friday trades.

The board filed a motion Monday to set a deadline of Jan. 21 for allowing objections to its procedures for handling the challenge. “It is very short, just seven days, given the significance of the issues involved,” Spiotto said. “Objectors may object to the short time period and whether it is consistent with due process to the creditors who would be affected by the procedure.”

Board General Counsel Jaime El Koury said the board's Special Claims Committee is still reviewing the deficit financing argument against the bond. Thus the board chose not to join that part of the objection.

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PROMESA Commonwealth of Puerto Rico Puerto Rico Public Buildings Authority Puerto Rico Sales Tax Financing Corp (COFINA) Puerto Rico Infrastructure Financial Authority Puerto Rico Industrial Development Co Puerto Rico
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