Down to day-by-day liquidity, shut out of the capital markets and uncertain about meeting payroll, the United States Virgin Islands (USVI) is, as its Senate President Myron Jackson put it, "experiencing a financial crisis of great proportions."

The USVI's financial situation has invited many comparisons to its fellow U.S. territory, Puerto Rico, especially after the enactment of the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) in June 2016.

At a high level, such parallels are not without logic. For both territories, the last decade was marked by deterioration in the competitiveness of important industries, steep population declines and rising debt levels. However, the two territories' funded debt obligations differ markedly in magnitude, legal structure and risk profile. In many ways, if Puerto Rico is a cup of coffee, the USVI is a shot of espresso.

USVI Capital Structure

The USVI has approximately $2.3 billion in total bond debt – in absolute terms, a mere fraction of Puerto Rico's $70 billion structure, but more on a per-capita basis, given a population of just over 100,000.

Most of this debt has been issued by the Virgin Islands Public Finance Authority (VIPFA), including $1.16 billion of Matching Fund Revenue Bonds (MFBs) and nearly $700 million of Gross Receipts Tax Bonds (GRTs). The MFBs (commonly known as "rum bonds") are paid from federal excise tax remittance, while the GRTs are backed by USVI-collected taxes as well as the territory's full faith and credit. In addition, the USVI's Water and Power Authority (WAPA) and Port Authority (VIPA) have outstanding, respectively, $253 million and $45 million of special revenue bonds (SRBs) backed by revenues from their corresponding systems.  

In connection with a planned issuance of new debt, in November 2016, the USVI passed legislation granting a statutory lien on the cash flows underlying both current and future MFBs and GRTs. Finding insufficient demand for that offering, the USVI sought shorter term financing. On March 22, 2017, it announced the still-pending sale of a nine-month $40 million property tax-backed Revenue Anticipation Note (RAN).

Matching Fund Bonds

The MFBs are backed by the remitted portion of excise taxes collected by the U.S. Treasury (UST) on USVI-produced rum sold in the mainland United States. Excise tax remittance operates through the application and interplay of USVI law and federal tax law. Each September, the USVI estimates the excise tax remittance for the following year and instructs the Department of the Interior (DOI) to direct the UST to pre-pay the funds along with any adjustment from the prior year.

As part of the MFB issuance, the USVI covenanted to direct the flow of funds directly to the trustee for payment of the bonds, rather than to its general account. In January 2017, attempting to assuage market concerns regarding the security of payment, Governor Kenneth Mapp issued an "irrevocable" instruction to the DOI regarding these mechanics. The legal significance of such a pledge is untested, and commentators and market participants are divided over its practical impact in the event of a future countervailing instruction.

As shown in the accompanying diagram, there are four distinct types of MFBs. Though rated at effectively the same level by the major agencies, MFB-specific structural priorities may result in differing recoveries in the event of a revenue shortfall. The Diageo and Cruzan MFBs, for instance, are paid last and only entitled to excise taxes remitted from sales by that individual rum producer. All of the MFBs face varying risks related to potential production agreement termination, which may result from events including the USVI failing to pay certain rum production subsidies or Congress reducing the "covered over" portion of the excise tax below $10.50 per proof gallon.

Gross Receipts Tax Bonds

Relative to the MFBs, the GRTs are structurally straight-forward. Each series of GRTs has equal priority, though some are federally taxable and, unlike the MFBs, a significant portion are insured. The GRTs are secured by both the USVI's 5% gross receipts tax and a general obligation pledge of the USVI government.

Logistically, the gross receipts tax is collected by the USVI at the time of sale and deposited in the general account. As part of the GRT bond indentures, the USVI has covenanted to make daily transfers of gross receipts tax collections to the bond trustee in order to service outstanding GRTs.

The gross receipts tax is broadly defined by statute – encompassing "all receipts, cash or accrued, of the taxpayer for services or derived from trade, business, commerce or sales. . ." – but narrowly applied in practice. Significant exemptions result in a relatively concentrated and limited base of tax payers with respect to the GRTs. Furthermore, the debt covenants may, under certain circumstances, allow the USVI to further expand the scope of exemptions, reducing the applicable cash flows.  

Creditor Considerations

The MFBs and GRTs differ with respect to both structure and economic exposure. Structurally, payment of the GRTs requires direct action by the USVI; its revenue service collects the tax and transfers it to the general fund, at which point the government must sweep it to the GRT trustee. In contrast, the flow of funds underpinning the MFBs is – or, at least, is intended to be – a step removed from the USVI. In accordance with historic practice and based on the irrevocable instruction, bond payments are sent directly from the U.S. treasury to the MFB trustee – the USVI government only receives funds left over after payment of the bonds and subsidies.

At the same time, and perhaps even more significantly, the matching fund revenues are exogenous to the USVI's economy. Presumably, absent a dramatic decline in mainland rum consumption, a change to federal tax policy, or adverse actions by the USVI, there should be sufficient excise taxes to pay the bonds. Payment of the GRTs, on the other hand, is endogenous to the USVI – gross receipts are only collected on sales, and a cooling economy means less business.

Sean A. O'Neal is a partner, and Lev Breydo is a law clerk, in the restructuring practice of Cleary Gottlieb Steen & Hamilton LLP.