The Commonwealth of Puerto Rico has a long history of fiscal uncertainty and structural deficits. Responding to decades of general fund deficits in 2014, the rating services lowered the ratings on the Commonwealth’s general obligation credit to below investment grade, or junk status.
The rating services downgraded Puerto Rico’s general obligation rating to BB (non-investment grade) in February 2014. The rating action had been long anticipated by the municipal market. The yields on the Commonwealth’s general obligation bonds exceeded 10% the month prior to the downgrade.
The Puerto Rico Corporations Debt Enforcement & Recovery Act (the Recovery Act), adopted on June 28, 2014, generated a subsequent wave of downgrades in July 2014. The ratings agencies notched downward Puerto Rico’s general obligation rating and Moody’s downgraded several public corporations a full rating grade to Caa.’
Moody’s cited as the rationale for the second round of downgrades that the Recovery Act signals a “ new preference for shifting fiscal pressures to creditors, which in our view, has implications for all Puerto Rico’s debt, including that of the central government.”
In response to the ratings services’ commentary on the Recovery Act and accompanying downgrades, the Commonwealth released the following statement: “This administration has implemented critical and decisive measures to stabilize Puerto Rico’s fiscal situation, promote economic growth, and safeguard and reinforce Puerto Rico’s credit. This includes the first balanced budget in 22 years We will continue to proceed with determination and focus to successfully guide Puerto Rico on its path to fiscal health and stability.”
The Commonwealth is a large economy, with gross domestic product (GDP) exceeding that of 15 U.S. states and population exceeding that of 22 U.S. states. Prior attempts to gain fiscal stability produced minimal results, primarily because of the Commonwealth’s policy of providing financial support to underperforming public corporations.
In 2012, the Commonwealth provided $1.0 billion of support to three public corporations. Governmental aid historically included liquidity, capital financing, and operating subsidies. This time, the Commonwealth’s arsenal includes the legislative ability to restructure select public corporations if commercial self-sufficiency is deemed unachievable. Puerto Rico’s potential elimination of annual, billion-dollar support to public corporations should materially strengthen the Commonwealth’s general obligation and related credits.
Puerto Rico’s challenges and progress
Structural deficits have persisted in the Commonwealth’s general fund for more than a decade. These deficits are the result of years of masking budgetary imbalances through Commonwealth bond sales and extending internal credit by the Government Development Bank for Puerto Rico.
The cumulative impact of past fiscal actions has resulted in a relatively high debt load coupled with constrained liquidity and market access. Puerto Rico has $72 billion of outstanding debt and obligations. The official statement for the Commonwealth’s $3.5 billion general obligation bonds, sold in March of 2014, contains 14 pages of risk factors. Issues cited as risk factors include:
- The Commonwealth may be unable to uphold its obligation to pay debt service on the 2014 General Obligation Bonds.
- Actions by the rating agencies, such as the recent downgrade of the Commonwealth’s credit ratings to non-investment grade, could raise the cost of borrowing.
- The Commonwealth’s very high level of debt may affect the performance of the economy and government revenue.
- The Commonwealth’s macroeconomic data may not accurately reflect the performance of the economy of Puerto Rico.
A common theme underlying these risk factors is that market access may become unavailable to the Commonwealth, resulting in an inability to obtain sufficient funds and liquidity from future debt offerings to meet obligations as they become due.
Cash flow initiatives to improve fiscal stability
While a headline may trumpet “Puerto Rico’s $72 billion of Debt,” the message skirts the core issue that cash flow, not debt, drives a government’s insolvency. The Commonwealth acknowledged the importance of governmental cash flow while developing the four key initiatives that form the foundation to their plan for fiscal stability:
1. Secure liquidity runway Puerto Rico’s recent $3.5 billion general obligation debt offering secured a material liquidity runway for both the Commonwealth and the Government Development Bank. Of equal note, the general obligation credit no longer has any financial obligations that are subject to acceleration.
2. Eliminate deficit financings The 2015 budget is the first budget in years to be void of deficit financings or include refinancing of maturing debt service. The budget imposes $1.5 billion of corrective expense measures in lieu of deficit financings.
3. Grow the economy Policy priorities include: (i) restoring Puerto Rico’s reputation as a business-friendly jurisdiction and (ii) offering businesses full advantage of Puerto Rico’s status as a U.S. jurisdiction.
4. Public corporations self-sufficiency Two recent legislative actions are central to making public corporations self-sufficient. The Fiscal Sustainability Act provides Puerto Rico’s public corporations additional tools to reduce public and private personnel expenses. The Recovery Act filled a statutory gap for public corporations to achieve debt relief that is not available under Chapter 9 or Chapter 11 of the Bankruptcy Code.
Governmental cash flow is core to each of these initiatives and provides the foundation to the Commonwealth’s zero budget deficit projected for 2015.19 Table 4 shows the Commonwealth’s cash flow for 2010 through 2013, along with the impact of pro-forma changes which governmental officials believe will be implemented over the next 18 months:
The administration faced a 2012 General Fund budget deficit of more than $2.3 billion. The 2013 deficit was cut to $1.4 billion with savings realized through a series of measures including: acceleration of tax receivables, tax amnesty program, sale of tax receivables, and closing agreements with two pharmaceutical companies.
The Commonwealth’s deficit for 2014 is projected to be $570 million lower than the 2013 deficit. The lower deficit was realized through enhanced General Fund revenues while simultaneously reducing reliance on deficit financings. Of note, the 4% excise tax scheduled to decline 1% per year to 1% in 2016 and then expire, was extended through 2017 and reset at a fixed rate of 4%. Excise tax revenues totaled $2.6 billion in 2013. Expense reductions, including a 9% public sector headcount reduction and limits on benefit increases from collective bargaining, resulted in a decrease in the Commonwealths projected expenditures for 2014 and 2015.
Public corporations
The Recovery Act, adopted on June 28, 2014, enables designated public corporations to restructure their debt in the event of financial distress. The goal of the law is to balance the interest of all creditors and stakeholders with the Commonwealth’s ability to provide essential services delivered via public corporations during periods of fiscal stress. The Commonwealth’s general obligation and related credits are not eligible for restructuring pursuant to the Recovery Act. Also excluded from the Recovery Act are 78 municipalities and Puerto Rico’s Government Development Bank. Therefore, all Commonwealth general obligation securities are required to be paid in full, while certain debt of Puerto Rico’s government corporations are eligible to be restructured.
The three largest public corporations that may be restructured pursuant to the Recovery Act have outstanding indebtedness totaling $20 billion:
Puerto Rico Electric Power Authority (PREPA) - is the government-owned electric power company exclusively responsible for electricity generation, power transmission, and power distribution in Puerto Rico.
Puerto Rico Aqueduct and Sewer Authority (PRASA) owns and operates Puerto Rico’s water and waste water system, servicing 97% and 57% of the Commonwealth’s population, respectively.
Puerto Rico Highways and Transportation Authority (PRHTA) is responsible for constructing and financing highways in Puerto Rico. Construction is financed through PRHTA’s revenues and debt issuances along with federal and Commonwealth grants.
The Recovery Act’s mandate for self-supporting public corporations is designed to eliminate the Commonwealth’s historical role of providing aid to underperforming instrumentalities. The attached table details current obligations and operating deficits in 2012 associated with these three public corporations.
Puerto Rico’s frameworks for debt enforcement
The Commonwealth enacted the Recovery Act to provide an orderly framework for debt enforcement. The law can be applied to reject or modify collective bargaining agreements, but pensions and retiree health benefits may not be impacted. The Commonwealth publicly positions the Recovery Act as a gap-filling measure with a stated strong preference for consensual resolution. Open dialogue with all creditors and stakeholders is a key principle of the Recovery Act.
Recovery Act settlement paths
The Recovery Act provides two distinct settlement paths:
Path # 1 - Chapter 2: Market based path whereby:
1. Public corporation designates the debt to be renegotiated,
2. Suspension period of 9 12 months during which consensual agreement is sought,
3. “Recovery Program” requires 50% of the creditors to vote and 75% of those voters to agree, and
4. Special judge approves and declares binding consensual debt relief.
Path # 2 - Chapter 3: Judicially supervised path whereby:
1. Public corporation files petition to initiate the process,
2. Affected creditors are stayed from exercising remedies during the proceeding,
3. Public corporation’s proposed recovery plan must make creditors better off than they would be if all creditors immediately enforced their claims, and
4. Upon one class of creditors’ approval, judge declares plan binding on all creditors.
Recovery Act legal challenge
Certain holders of PREPA bonds have challenged the constitutionality of the Recovery Act on multiple U.S. Constitutional grounds. The bondholders’ Constitutional challenges and the Commonwealth’s response include:
- Preemption
Challenge: The U.S. Congress’ Bankruptcy Code already applies to Puerto Rico.
Commonwealth response: U.S. Supreme Court rejected the argument that federal Bankruptcy Code precludes states and territories from passing restructuring laws when no conflicts exist. - Impairment of contracts
Challenge: The U.S. Constitution prohibits states from impairing contracts. Commonwealth response: U.S. Supreme Court held contractual impairment is permitted to achieve an important governmental purpose. - Unconstitutional taking
Challenge: The U.S. Constitution forbids public taking of private property. Commonwealth response: U.S. Supreme Court precedent that economic regulations rarely result in an economic deprivation, which rises to an unconstitutional taking.
Supporting the Recovery Act, Puerto Rico’s Secretary of Justice, César R. Miranda Rodríguez, stated: “The U.S. Supreme Court has clearly established a sovereign’s right to pass debt enforcement laws when such relief does not conflict with the federal law
We stand behind the Act and will defend it as a reasonable and necessary measure to protect the interests of everyone associated with our public corporations and the Island as a whole.”
At this time, any future action taken or decision made by the United States District Court is difficult to predict.
Chapter 9 Congressional Uniformity Act
Subsequent to the enactment of the Recovery Act, Pedro Pierluisi, Puerto Rico’s sole non-voting member of Congress, introduced the Puerto Rico Chapter 9 Uniformity Act of 2014 (the Uniformity Act) that would authorize Commonwealth-designated public corporations to enter Chapter 9 municipal bankruptcy. The Act does not change the fact that Puerto Rico, like all 50 states, is not eligible for bankruptcy.
Congressman Pierluisi advanced the legislation with his belief that the Uniformity Act is a more direct and predictable pathway, relative to the Recovery Act, for fiscal restructuring. With the introduction of the Uniformity Act, the Commonwealth is now pursuing parallel paths to acquire the sovereign right, currently held by all 50 states, to restructure local municipal obligations.
The next chapter
The Administration, Legislature, and Congressional representatives have all acted upon the urgent need to restructure Puerto Rico’s public corporations that cannot stand on their own. Management of PREPA, one of Puerto Rico’s three largest public corporations, is in conversations with creditors on “a consensual path forward to improve its operations and financial situation.” How the Commonwealth ultimately avails itself of the equivalent of Chapter 9 municipal bankruptcy is still an open issue. What no longer appears to be a question is the political will to balance the General Fund, even at the expense of the Commonwealth’s favored private corporations and instrumentalities.
Regardless of the path taken to secure Chapter 9 equivalent rights, once acquired, time becomes the new uncertainty for Puerto Rico’s inventive fiscal paradigm. Specifically, if commitment remains steadfast and the new programs have the planned effect, how long will it take for:
- Rating agencies to restore Puerto Rico’s investment grade rating?
- Municipal bond market participants to recalibrate Puerto Rico’s value perception?
The Commonwealth’s focused and decisive actions should drive the narrative, but only time will tell if the “next chapter” narrative for Puerto Rico is one of fiscal stability.
