Puerto Rico Salsas On Cliff's Edge

by: Joan Feldbaum-Vidra

Summary

The recent public corporations' restructuring law is an attempt by the Puerto Rican government and legislators to ring-fence GOs and COFINA debts, and secure their creditworthiness.

Question marks around the legislation introduce even more uncertainty about the Commonwealth's debt prospects.

Puerto Rico's economy and the government are what need to be restructured before its debts, in that order.

It is hard to see that the recent policy moves in Puerto Rico offer a lasting solution or much clarity to investors. While the recent public corporations' restructuring law is an attempt by the Puerto Rican government and legislators to ring-fence GOs and COFINA debts, and secure their creditworthiness, question marks around the legislation introduce even more uncertainty about the Commonwealth's debt prospects.

The legal battle against the debt restructuring law, ironically titled the Puerto Rico Public Corporations Debt Enforcement and Recovery Act, seems to hold a lot of water. Of course, given the lack of precedence, it's hard to predict with surety what the courts will decide, but what is for sure is that a long drawn-out battle is likely in front of us. I have spent the last few days speaking to many legal experts and economists about the validity of the legal case launched by OppenheimerFunds and Franklin Templeton. Most experts expect that the plaintiffs may win the lawsuit against the Commonwealth.

There are several reasons why the Puerto Rican debt restructuring law is likely to be found unconstitutional. First, bankruptcy in the US is under the jurisdiction of Congress, and not the individual states. This ensures uniform treatment of bankruptcy proceedings and creditors' rights.

Second, the Commonwealth and Puerto Rico are explicitly excluded from coverage in the US Chapter 9 bankruptcy law (along with the District of Columbia). While the Commonwealth is betting that the explicit exclusion provides room for it to legislate its own bankruptcy law, that is unlikely to be found reasonable in a court of law. This case boils down to the Commonwealth's audacity in designing its own Chapter 9 law and labeling it something else.

There are other legal problems as well, but these have more second derivative risks, as they would be considered only after the law would be deemed constitutional and only if public corporations do end up filing for bankruptcy. Of course, PREPA, the beleaguered electric utility, is the top candidate to use the law first, given its dire cash flow situation. If PREPA files for bankruptcy, it would easily be challenged on the issue of "just compensation," partly given that it has made virtually no attempts to modify its expenses to allow it to pay its debts. Some options the utility could take to prevent debt restructuring, as unpalatable as they seem, are fee hikes and slashing labor expenses. This would put some money in its coffers. Improving collections would also go a long way to assist its financial health, especially from its biggest accounts payable item, the General Fund.

PREPA made its bond payments this week, putting up to question the timing of the legislation. Is the government worried about the legal challenges it faces? Perhaps the payments are part of an effort to stall the present legal challenges, bringing up an issue of "ripeness." In other words, since PREPA is paying its debts, the case against the law has no ripeness or practical merits, even though the existential legal and constitutional question marks still remain.

In the midst of all this, Puerto Rico passed its first balanced budget in a long time with few if any accolades, despite solidifying its comfortable primary surplus position. And why is this? The answer is partly found in last year's fiscal outcome. The government raided COFINA funds (whose debt payments are backed by sales tax receipts and immune to clawback from the government) and also utilized some other creative forms of financing to plug the gap created by abysmal corporate tax collections ($380 million below expectations). The General Fund continues to run arrears to PREPA too, overlooked in its cash-basis accounting. Puerto Rico's comfortable primary surplus normally would calm the government debt market, but in this case, the public corporation debt restructuring law and the budget details confound it.

Indeed the recent multi-notch rating adjustment for the GOs by Moody's reflects market concern about the Commonwealth's willingness to pay its bond obligations.

The Puerto Rican Congress is in recess, but it would be well placed to quickly pass the tax reform that we have all been waiting for. While such a reform will create more headwinds for the Commonwealth's nonexistent economic growth, at least it will enable it to bolster its public finances, both for the General Fund and for COFINA.

The economy and the government are what need to be restructured before its debts, in that order. This would help place the Commonwealth on solid economic footing, creating a more stable and business-friendly environment for investment, and thereby providing conditions that could unleash growth, assist employment creation, and create a positive virtuous cycle for Puerto Rico.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.