The first hearing of the Puerto Rico Title III case on Wednesday reinforced expectations that the battle between general obligation and Puerto Rico Sales Tax Financing Corp. (COFINA) bondholders will be a central issue as the biggest municipal restructuring gets underway.

“The issue of how to treat GO versus COFINA bondholders is one of the key decisions that the Title III process will need to resolve,” said AllianceBernstein director of municipal credit research Joseph Rosenblum. “And it is likely to have a significant impact on other classes of debt.”

Rosenblum said reports on the case had reinforced these beliefs. “We are just at the beginning of getting to a final answer.”

Purto Rico attorney John Mudd said he believed the Title III judge would order a delay in the June 1 COFINA payment.
John Mudd

Holders of Puerto Rico's GO bonds point to the Puerto Rico constitution, which says that the first use for any available government revenue should be to pay off the commonwealth's debt.

Sales and use taxes that flow into a lockbox are used to pay off the COFINA bonds. Because the revenues that go to the bondholders never flow through the government's coffers, COFINA holders argue that the revenues are not available government revenues.

Whereas the commonwealth defaulted on its GO debt on July 1, it has continued to pay its COFINA bonds. COFINA holders have said the Puerto Rico government has taken steps recently towards not paying all of the COFINA debt in the next fiscal year, which starts July 1.

The court case puts the GO and COFINA holders on a collision course as the court operates in the shadow of an Oversight Board fiscal plan that allows payment of just 24% of debt service over the next 10 years. Puerto Rico Gov. Ricardo Rosselló has said the Puerto Rico Oversight, Management, and Economic Stability Act requires the judge to observe the board's fiscal plan.

As of February there was $13.3 billion of GO debt and $17.9 billion of COFINA debt outstanding, according to the board's fiscal plan.

On Tuesday COFINA bond trustee Bank of New York Mellon filed an adversary complaint in the COFINA Title III case. In response to suits from COFINA bondholders, the bank asked Title III Judge Laura Taylor Swain to declare that it hasn’t done anything wrong as a trustee and to allow it to enlist a separate entity to serve as trustee for the subordinate COFINA bonds. Currently, the bank is trustee for both the senior and subordinate COFINA bonds.

Senior, subordinate, and capital appreciation holders of the bonds all have different ideas about what should be done with the bonds, said Puerto Rico attorney John Mudd, who was at the hearing to represent an architectural supplier that Puerto Rico’s government owes money to. Puerto Rico’s Fiscal Agency and Financial Advisory Authority, representing Puerto Rico Gov. Ricardo Rosselló, has yet another position.

At Wednesday’s hearing Puerto Rico Oversight Board attorney Martin Bienenstock said he might get a lawyer to represent yet another COFINA interest – that of the COFINA entity itself, Mudd said.

On June 1 COFINA owes $16 million in bond payments. Swain will probably order this money to be held while she considers what to do with the COFINA bonds, Mudd said.

The COFINA bondholders wanted to separate their Title III case from that of the GO holders, Mudd said.

Swain said the two cases would be joined for administrative purposes but not legally melded into a single case.

Mudd said this will simplify managing the case for the judge and board. For example, with this sort of merger she can simultaneously file in both cases whereas previously she would have to file twice.

The board will have to notify creditors about the case. With administrative consolidation, if a single entity holds both GO and COFINA bonds they will only have to be notified once as opposed to twice, as had been the case, Mudd said.

Swain has yet to sign an order to join the administration of the cases.

One observer said Wednesday’s hearing wasn’t what he expected. Gil Hall, who is writing a book about the Puerto Rico debt crisis, said Swain was very calm and firm. When she didn’t understand things, she interrupted lawyers and asked for things to be re-explained.

She repeatedly asked the lawyers representing different groups to come up with temporary compromises. In these ways, she was a valuable counter to the lawyers’ testosterone, he said.

Swain is likely to push the two sides to use mediation, he said.

In the hearing Swain gave the government 60 days to present a list of creditors.

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Corrected May 19, 2017 at 4:51PM: And earlier verison misstated the amount that COFINA owes bondholders on June 1.