The economic and storm-related woes of Puerto Rico are of a scale that regrettably ensures plenty of human and financial pain for the foreseeable future. Under the best of circumstances, participants in our financial systems sometimes elevate short-term results or tactics over longer-term consequences; stressed situations, including large scale financial meltdowns, can exacerbate such tendencies. The battles among Puerto Rico officials and various creditor groups to maximize their respective slices of Puerto Rico’s depleted resources already have yielded several decisions with legal implications that are not salutary for the market as a whole. Some of the legal precedents potentially being set, whether or not technically binding outside Puerto Rico or the 1st Circuit, erode the expectations and good order of the municipal bond marketplace that finances the activities of states and municipal instrumentalities nationwide.
It is unsurprising that creditors and Puerto Rico officials would employ all available legal tactics to achieve what they perceive as an outcome that makes the best of a bad situation for their respective interests. Federally-established institutions such as the financial oversight management board for Puerto Rico (FOMB) and the federal district court to which Puerto Rico’s Title III insolvency proceedings have been assigned, in contrast, should be expected to balance the legitimate, and legally-founded, interests and expectations of Puerto Rico and its creditors. It is unsettling, therefore, that the FOMB and the federal district court are at the center of decisions which market participants perceive as circumventing or disregarding inconvenient, to Puerto Rico, provisions of both Puerto Rico and federal bankruptcy law.
These developments in the Puerto Rico bond battles have led some market participants to question whether the rule of law is a meaningful concept in such meltdowns, never a healthy development for a market involving investment of trillions of dollars. The list of particulars below is illustrative:
FOMB challenges Puerto Rico’s own bond structure
After years of unchallenged use by Puerto Rico of the COFINA securitization structure to access the bond market at lower interest rates, and years of Puerto Rico Justice Department opinions as to the validity of the COFINA structure, the FOMB, representing the Puerto Rico debtor instrumentalities, has instituted a legal challenge to the validity, under Puerto Rico law, of the transfer to COFINA of a portion of sales tax revenues that is the only source of payment for over $16 billion in currently outstanding COFINA bonds. This legal challenge claims that the Puerto Rico statute transferring the relevant sales taxes to COFINA is invalid under the Puerto Rico constitution and/or does not effectively transfer to COFINA the revenues the legislation explicitly says it transfers.
The FOMB is an odd duck legally. Created by federal law (PROMESA) and appointed by the U.S. President, the board is the representative of Puerto Rico and its instrumentalities as debtors in PROMESA Title III insolvency proceedings. Per PROMESA, the FOMB is “created within the [Puerto Rico] government.”
As the federally-constituted voice of Puerto Rico, the FOMB is sponsoring an argument over the validity and effectiveness of Puerto Rico law. In order to be somewhat less overt in the undermining of Puerto Rico’s own financing structure, the FOMB, speaking for Puerto Rico and COFINA, has deputized “agents” tasked with litigating against each other over whether the sales taxes statutorily transferred to COFINA belong to COFINA or the Commonwealth’s General Fund. The FOMB’s, and therefore Puerto Rico’s, “agents” in this litigation are Bettina Whyte, a restructuring specialist from the private sector (advocating for the transfer being effective) and the unsecured creditors committee in the Commonwealth’s PROMESA Title III bankruptcy (advocating against the transfer being effective).
The FOMB, while purportedly neutral on the outcome, has (a) agreed essentially to sue itself in order to “resolve” a “dispute” between The Commonwealth of Puerto Rico and COFINA and (b) filed briefs stating that there are “powerful” arguments on either side of such “dispute.,” The briefs include questions such as “Does a law providing the [sales] taxes cannot be used by the Commonwealth frustrate Congressional intent that the Oversight Board restore the Commonwealth to fiscal responsibility by requiring certain types of fiscal plans and budgets?” These are leading questions that appear to signal an oxymoronic position by the FOMB that Puerto Rico’s “fiscal responsibility” might be promoted by invalidating “frustrating” Puerto Rico laws that induced bondholders to lend to Puerto Rico. The appointment of “agents” to litigate the “dispute” reflects FOMB‘s conflicted status as representative of both the Commonwealth of Puerto Rico and COFINA; however, the “agented” Commonwealth vs. COFINA adversary proceeding fails to acknowledge or resolve the conflict, indeed unsavoriness, inherent in the Commonwealth of Puerto Rico attacking the validity of its own law.
There is no duty that compels a government to impugn its own law. If creditors of the Commonwealth wished to challenge the COFINA arrangement, they should have been permitted to do so (subject to applicable standing requirements) with Puerto Rico, or its representatives, defending the validity of the COFINA statute under Puerto Rico law as any sovereign that has enacted laws to encourage investment normally would. Instead, the FOMB, on behalf of Puerto Rico, at a minimum has washed its hands on the question of whether the COFINA statute is valid under Puerto Rico law. What’s more, despite its purported neutrality, the FOMB has suggested reasons why the federal court should rule against the COFINA statute’s validity. Just as it would be legal hypocrisy for Puerto Rico, after a decade of assuring the bond market that the COFINA structure is valid, to question the legality under Puerto Rico’s own laws of the COFINA structure, it is legal hypocrisy for the FOMB, representing Puerto Rico, to lend its name and “questions” to a process premised on alleged ambiguity as to whether the COFINA structure is valid.
The FOMB has attempted to justify its support of litigation in its own name over the validity of Puerto Rico law that has stood unchallenged for a decade, while billions of general obligation and COFINA bonds were issued, by asserting that settlement discussions cannot proceed while there remain unresolved allegations by certain Commonwealth creditors that the COFINA statute is invalid under Puerto Rico‘s constitution. Even if expediting settlement discussions were a justification for the FOMB’s endorsement of a process for expedited resolution of creditor claims that the COFINA statute is invalid or ineffective, it does not justify the FOMB, as Puerto Rico’s voice, taking a position that Puerto Rico has not itself expressly promoted, namely that Puerto Rico has no view on the validity under Puerto Rico law of a Puerto Rico statute under which it borrowed billions of dollars. The FOMB, by permitting its “agent”, and thereby Puerto Rico’s “agent,” to argue against the validity of a Puerto Rico statute promoted as valid by Puerto Rico for a decade, and by contributing its non-neutral commentary on the “dispute” it has facilitated, is participating in the debasing of the bond market’s ability to rely on the legal underpinnings of municipal bond issuance.
A Puerto Rico government that stands behind its laws and financing structures would not be a participant, whether directly or through “agents,” in any attempt to blow up those laws and invalidate the COFINA financing structure. The FOMB, by lending its authority to efforts to topple the COFINA structure instead of backing its validity, invites serious questions about whether it is using its statutory appointment as Puerto Rico’s representative to take inappropriate legal shortcuts. It is opening a Pandora’s box that creates a new risk of statutory validity challenges, no matter how long a statute has been in effect, as a deleveraging strategy for municipal issuers or their federally-appointed overseers.
The federal district court’s special revenues ruling
If any federal judge deserves sympathy for having to drink continuously out of the proverbial firehose, it is Judge Swain, who is faced with an ongoing barrage of complex decisions involving Puerto Rico’s highly convoluted debt structure and multiple debtors and insolvency proceedings. Particularly of late, however, the federal district court to which the Puerto Rico Title III proceedings have been assigned has issued a series of opinions dismissing creditor complaints in a manner that is disruptive of market understandings of legal protections available for municipal bonds in bankruptcy scenarios.
A notable example is the court’s ruling in the Puerto Rico Highway Transportation Authority (PRHTA) Title III proceeding that holders of special revenue bonds are not entitled to pursue relief to compel the debtor bond issuer to apply the net special revenues (after deduction of reasonable operating expenses) securing the bonds to the payment of debt service due on the bonds. Section 922(d) of the Bankruptcy Code expressly exempts from the bankruptcy stay “the application of special revenues … to payment of indebtedness secured by such revenues.” In its PRHTA opinion, the federal court went where no court has gone before, opining that the Section 922(d) exception does not authorize actions to compel the debtor to apply the net special revenues to debt service. The court’s decision ignores legislative history indicating that Section 922(d) was intended to avoid impairment of special revenue bonds in bankruptcy, asserts that Section 922(d)’s purpose was to permit the debtor to apply special revenues to debt service in order to preserve future market access (nothing in PROMESA precludes such voluntary application by the debtor, so Section 922(d) is unnecessary for such purpose), and claims that a contrary opinion by Judge Bennett in the Jefferson County Chapter 9 proceeding is not contrary when it manifestly is. The federal court ruling is not only suspect but highly disruptive of market understanding that special revenue bonds are entitled to payment from available net special revenues during and after a municipal bankruptcy proceeding.
The federal district court’s Section 305 ruling
In a series of opinions, the federal district court entrusted with the Puerto Rico Title III cases has read Section 305 of PROMESA in an implausibly broad manner so as to virtually read out of the statute the right of creditors to obtain relief from stay. Section 305, which is modeled on Section 904 of Chapter 9, states in relevant part that the district court “may not, by any stay, order or decree, in the case or otherwise, interfere- … with any of the property or revenues of the debtor.” The district court’s opinions suggest that it interprets Section 305 as precluding a federal court from granting relief from stay so that a creditor can pursue relief (in territorial court, by self-help or otherwise) for the debtor’s misapplication of its revenues or funds. Section 305, which like Section 904 is driven by federalism concerns, has no application to actions by a creditor; the “interference” with debtor decision-making and actions it precludes is interference by the federal court.
The district court’s interpretations ignore the actual text of Section 305 and a contrary ruling in the Jefferson County Chapter 9 proceeding, as well as provisions of the Bankruptcy Code expressly incorporated into PROMESA permitting the lifting of the bankruptcy stay for cause, including for lack of adequate protection. Lifting the stay so that a creditor can seek to protect its interests simply leaves the debtor in the same position it would be in absent the stay; it does not “interfere” with any of the debtor’s operations or use of property. The federal court’s propensity to interpret Section 305 in a manner that precludes a creditor from exercising self-help when its security or source of payment is adversely impacted or obstructed by debtor action appears unfounded and disruptive of market understanding.
The federal district court’s contract impairment ruling
In an adversary proceeding in PRHTA’s Title III case, the federal district court dismissed creditor claims alleging that moratorium legislation and fiscal plan compliance legislation enacted by Puerto Rico effected an impairment of contract in violation of the “contracts clause” of the U.S. Constitution. The challenged legislation precludes certain transfers of revenues for the payment of debt service. The district court, citing 1st Circuit precedent, correctly noted that the “contracts clause” has been judicially construed to apply only if state legislation causes a “substantial impairment” of contractual rights and that, even then, there is no constitutional “impairment” if the legislation is “reasonable and necessary to fulfill an important government purpose.” Curiously, the district court’s opinion did not reference the portion of the same 1st Circuit opinion which quotes U.S. Supreme Court precedent stating that “where the state is alleged to have impaired a public contract to which it is a party, ‘less deference to a legislative determination of reasonableness and necessity is required, because the State’s self-interest is at stake.’”
The district court assumed in its decision that the creditors in the PRHTA case had adequately alleged a substantial impairment of their contractual rights by the moratorium and fiscal compliance legislation. However, the court quoted references to a “fiscal emergency” in both the moratorium legislation and PROMESA, and found insufficient the creditors’ allegation that Puerto Rico has sufficient cash to pay debt service and provide “essential services.” According to the court, “[p]laintiff’s narrow focus on the feasibility of GO and revenue bond debt service is inconsistent with the breadth of the fiscal, public health, safety, welfare and recovery concerns that combine to form the crisis the [Puerto Rico legislation] purports to address.”
The court further stated that “[p]laintiff has not pled facts that support an inference that a ‘more moderate course of action’ to marshaling revenue than ‘the sweep[ing] [of] vast sums of money from across the Commonwealth’ would have both served the stated purposes of addressing the critical public health, safety and welfare aspects of the crisis, as well as restoring the Commonwealth’s, and its instrumentalities’, access to the capital markets.” Although it is possible that more specific pleading of why Puerto Rico’s fiscal emergency does not require or justify current cessation of all debt service payments might receive a better reception in other contexts, the wording of the federal district court’s opinions, as well as the court’s rulings on adequate protection, special revenues and Section 305, raise the prospect that no matter what legal argument is made, the district court will find that Puerto Rico’s approach to addressing its fiscal troubles overrides creditor interests, versus striving for a compromise between the respective interests.
The role of legal protections in municipal insolvencies should neither be overstated nor understated. Sometimes investors, even municipal bond investors, make what turn out to be unfortunate investments. Legal protections cannot rectify overleveraging, revenue shortages or expense proliferation due to unforeseen circumstances, and both for societal good order and the enlightened self-interest of creditors, governmental entities and their instrumentalities must be permitted to continue servicing their citizens, taxpayers and ratepayers. But just as taxes are the price we pay for a civilized society, so are laws. It is short-sighted for government officials and judges to engage in results-oriented shortcutting of legal principles. Erosion of trust in principles and statutes specifically written to address situations of financial distress may impact both governments and investors in discouraging the leap of faith inherent in lending money to municipal issuers in the expectation of future repayment, and the impact may be felt not only by Puerto Rico when it attempts a return to the bond market for financing, but also by other municipal issuers.