How a judge's opinion shakes up Puerto Rico's debt restructuring

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Congress may come under pressure to revise or repeal the Puerto Rico Oversight, Management, and Economic Stability Act, after a federal judge suggested the the U.S. government could be liable for cuts to bond values mandated by the Oversight Board.

U.S. Court of Federal Claims Chief Judge Susan Braden issued the opinion on Friday in the case filed by investment funds against the U.S. government concerning defaulted employment retirement system bonds. Braden's signal that she was inclined to rule in favor on the claims drew reactions from members of the Puerto Rico Task Force of the Congressional Hispanic Caucus.

“This ruling exposes additional problems with the PROMESA act,” said U.S. Rep. Darren Soto, D-Fla. “It may also be a catalyst to support a reform or repeal to provide Puerto Rico full bankruptcy rights.”

U.S. Rep. José Serrano, D-N.Y., agreed that the opinion may have an impact on Puerto Rico but he wasn’t sure it would be for the better.

“By making the U.S. government liable for Puerto Rico’s debt, the court has essentially determined that bondholders can have priority over the needs of the Puerto Rican people," Serrano said. "This would force the federal government to make the hedge funds whole, rather than focusing on the true intent of PROMESA — helping Puerto Rico get on a sustainable economic and fiscal path. We have to make sure the people of Puerto Rico come first.”

Manal Mehta, founder of Sunesis Capital, agreed the ruling would help bondholders, and saw this as a positive. “The plaintiffs had to get over the hurdle to show this is actually a claim against the federal government to get to federal claims court. This is a solid win for creditors.” Sunesis owns stocks in bond insurers with Puerto Rico exposure.

“It looks like the court made the correct decision, as the Lebron [legal case] test emphasizes ‘federal control’ to determine whether something is ‘federal’ for takings purposes, and it’s clear Congress controls the Oversight Board, as it appoints it,” Mehta continued. “So there’s now a takings route for creditors, at least in situations where the Oversight Board/government has wiped out pre-petition collateral, and it’s unlikely to be overturned.”

“Until final adjudication, this ruling strikes a dagger at the heart of the legitimacy of the Oversight Board,” Mehta said. “I suspect that this will lead Congress to remove and reappoint members of the Oversight Board in a manner that is consistent with the appointments clause of the Constitution as well as modify Title III of PROMESA to ensure that the federal government doesn’t become liable for creditor claims.”

Some market observers saw the development as a setback for an orderly debt restructuring. “Changing the rules of the game after the fact is dangerous and potentially very disruptive to the markets,” said Robert Chirinko, finance professor at the University of Illinois at Chicago.

Others saw the legal situation to be in flux. “Judge [Laura Taylor] Swain made a somewhat contrary ruling,” said Brad Setser, senior fellow at Council on Foreign Relations. In a decision on Friday, Swain, the judge in the bankruptcy proceeding authorized under Title III of PROMESA, said that the Puerto Rico Oversight Board was part of Puerto Rico’s government and not the federal government. Braden’s ruling reached the opposite conclusion.

“There’s a good chance this ruling will be appealed," a spokeswoman for U.S. Rep. Nydia Velázquez, D-N.Y., said. "The congresswoman will reserve judgment as the legal process unfolds.”

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PROMESA Puerto Rico Employees Retirement System Commonwealth of Puerto Rico Puerto Rico Sales Tax Financing Corp (COFINA) Puerto Rico Highway & Transportation Authority Puerto Rico Electric Power Authority Puerto Rico