Many of the biggest municipal bond underwriters remain exposed, after a federal court decision, to a possible major judgment against them for their role in the Puerto Rico debt meltdown.
In a late February decision, U.S. District Judge Laura Taylor Swain sided with the underwriters and other financial firms on most issues but left open a potentially major liability for the firms.
The Puerto Rico Oversight Board and Unsecured Creditors Committee tasked a firm, Drivetrain LLC, with overseeing avoidance actions — lawsuits filed by a trustee to revoke or "avoid" certain transactions prior to a bankruptcy filing — in the Puerto Rico central government bankruptcy.
Drivetrain is seeking the recovery of underwriting and swap termination fees for more than $13.46 billion of Puerto Rico bonds underwritten by firms. It also,
Swain said the argument that the bonds were issued illegally has sufficient evidence for more pleading and for introduction of evidence to continue.
The defending firms said under Puerto Rican law if both sides are responsible for an illegal contract, as Swain says may have been the case here, then no recovery of the money can be made. Drivetrain argued that even if both sides were responsible for such a contract, Puerto Rico could still recover funds.
Swain said she wasn't ready to decide the issue.
Swain filed her opinion and order in late February in an adversary proceeding in the Puerto Rico bankruptcy. Since then, U.S. Magistrate Judge Judith Dein, who is aiding Swain, ordered the parties to meet by March 24 to discuss how the case should continue.
The parties were then to promptly propose the schedule to the court. As of Wednesday morning no such proposal had been filed with the court.
The defending firms are Barclays Capital, BMO Capital Markets GKST, BofA Securities, Citibank N.A., Citigroup Global Markets, Goldman Sachs & Co., Goldman Sachs Bank USA, Goldman Sachs Mitsui Marine Derivative Products, Jefferies, J.P. Morgan Securities, Merrill Lynch Capital Services, Morgan Stanley & Co., Morgan Stanley Capital Services, RBC Capital Markets, Royal Bank of Canada, Samuel Ramirez & Co., Santander Securities, UBS AG and UBS Financial Services of Puerto Rico.
The Oversight Board put the commonwealth
In January 2022, U.S. District Court for Puerto Rico approved a plan of adjustment for the bankruptcy that included establishing an avoidance action trust to litigate avoidance actions. Drivetrain was appointed trustee.
Drivetrain
Drivetrain in its complaint also said that underwriters encouraged a 2014 general obligation bond sale, knowing the commonwealth would not be able to repay this debt, and that some proceeds were used to refund and retire Puerto Rico bonds they or their affiliates held.
"Specific information about which defendants received interest and principal payments from the proceeds of the bonds they underwrote, and in what amount, is in the unique knowledge of the defendants," the Drivetrain complaint says.
In her opinion and order, Swain took the second amended complaint's five counts and rejected three of them outright with prejudice. She rejected two other counts partially and left one of these two alive on condition that Drivetrain provided further evidence for it within 21 days of her ruling. She said, "because the trustee has failed to state fraudulent transfer claims under either New York or Puerto Rico law with respect to the principal and interest payment, the remaining Count 5 claim is dismissed."
The 21-day period since elapsed without a Drivetrain filing so Swain may dismiss the balance of the Count 5 claim as well.
In Counts 1 and 3 to 5, Drivetrain was seeking, among other things, for the court to order the underwriters to return swap termination and underwriting fees.
That would leave Count 2 with regard to possibly recovering principal and interest from the defendants. In Count 2 Drivetrain argued that under Puerto Rico law, agreements contrary to law should be considered illegal. It said the Employees Retirement System bonds and what it calls "excessive debt" and "scoop and toss" bonds were illegal for various reasons.
Count 2 quoted Puerto Rico law, "Acts executed contrary to the provisions of law are void except when the law preserves their validity." It also quoted a local law that says, "Contracting parties may make the agreement and establish the clauses and conditions which they may deem advisable, provided they are not in contravention of the law, morals or public order."
The contested bonds were contrary to law and public order, Drivetrain argued.
Counts 1, 3, and 4 sought to recover underwriting and interest rate swap fees. Swain rejected Drivetrain's arguments primarily as being made too late after the events.
The bonds at stake in the case were issued between 2008 and 2014. They are Puerto Rico's general obligation Series 2007A-4, 2009A, 2009B, 2009C, 2011A, 2011C, 2011, 2011D, 2011E, 2012A, 2012B and 2014; Puerto Rico's Public Buildings Authority Series P, Q, S and U; and Puerto Rico's Employees Retirement System Series A, B and C bonds.
Drivetrain argues the bonds were illegal for several reasons. It says the underwriters knew of Puerto Rico's inability to repay the debt. They also knew some of the bonds were issued in contravention of the territory's constitutional debt limits. The Employees Retirement System was ineligible to issue public bonds but the underwriters participated in their issuance anyway, Drivetrain said.
The territory used new debt to pay off old debt and extend maturities. This "scoop and toss" was an inappropriate and illegal practice, Drivetrain said.
The trustee claims that such actions exacerbated the commonwealth's debt crisis and economic deterioration.
The defending firms urged Puerto Rico to issue all the bonds and profited from their issuance, Drivetrain said.
Swain dismissed Count 2 insofar as it sought recovery of swap termination and underwriter fees but let it survive in so far as it sought to recover principal and interest.
In her opinion and order, Swain said she had the right to determine if the bonds used for "scoop and toss" were issued for a proper public purpose. She said there needs to be more briefing on the Puerto Rico constitution and more factual information about the bonds presented, before she could make a ruling.
In their response to Drivetrain's second complaint in May 2023, the defending underwriters said, "The refinancing bonds had a public purpose: they raised funds for the commonwealth allowing it to provide public services and avoid default." They went on to quote a 2020 Puerto Rico court decision, "The 'initial determination from the political branches as to what constitutes a public purpose deserves great deference,' and '[i]t is not the role of the courts to scrutinize on the wisdom or expediency of a legislative measure.'"
