Puerto Rico's Constitution does not permit the issuance of debt payable from general fund revenues other than general obligation bonds and guaranteed bonds. GO bondholders could have blocked the original issuance of Puerto Rico Sales Tax Financing Corporation (COFINA) on that basis but did not.
If asked, on what basis would a court of law find the act creating COFINA bonds unconstitutional and invalid under the Commonwealth's Constitution?
With a missed payment on GO bonds, there is no doubt that one or more holders of GO bonds will go to court challenging the constitutionality of the legislative act that created COFINA and the mechanisms moving sales tax revenue out of the general fund to pay COFINA bond P&I.
Not diverting funds to pay COFINA P&I would add $600 million more in revenue, increasing to $1 billion that would be available to pay the Government's only enforceable debt and other expenses. Add to that about $550 million in annual optional pay P&I and total general fund revenues increase by more than 15 percent. Debt service claims are eliminated by the same amount.
P&I on GOs and guaranteed bonds will equal about 12% of general fund revenues with restoration of the diverted sales tax revenue. That would leave additional GO bonding authority under the 15 percent constitutional limit. Free of those other encumbrances; reacceptance of the Commonwealth's GO bonds would be rapid and lines of credit would reopen.
No court has opined on the validity of COFINA bonds, which is unusual for a never before seen kind of bond structure at the state level.
The legal opinion on COFINA bonds provided by Nixon Peabody includes the following:
"The Bonds are limited obligations of the Corporation payable solely from, and secured by a pledge and assignment of, the Pledged Sales Tax derived from a portion of the Commonwealth Sales Tax (to the extent received by the Trustee under the Resolution)…
Based upon the foregoing, we are of the opinion, under existing law, as follows:
3. The proceedings of the Corporation in connection with the authorization, issuance and sale of the Bonds have been validly and legally taken.
4. Act 91 and such proceedings show lawful authority for the issuance and sale of the Bonds by the Corporation.
5. As authorized by Act 91 and by said proceedings, the Resolution has been duly adopted by the Corporation and constitutes the legal, valid, binding and enforceable obligation of the Corporation. "
The last time debt of a U.S. State corporation was declared invalid, not payable or not worth the paper printed on, happened in 1985 when about $2.3 billion of Washington State Public Power Supply System Nuclear Projects Number 4 and 5 Bonds were declared invalid by Washington's highest court. In that case, there wasn't a federal issue and no appeal was made to the U.S Supreme Court. Bond investors had no recourse and only bond counsel to go after.
Until now that was the only time in at least 75 years that a court held outstanding state or municipal bonds invalid and not payable.
Conventional wisdom accounts for a current market yield on COFINA bonds that is lower than the current yield on GO bonds. What the market has completely missed is that the trading differential makes sense only if the entity was a municipality, not a U.S. State or Commonwealth. The latter can default but cannot seek protection in bankruptcy proceedings
Further, no U.S. state has ever deployed sales or income tax general fund revenue to secure debt of the state or a state corporation absent specific constitutional authorization to do so. Conventional thinking about revenue and GO bonds does not apply here.
What is optional pay debt, AKA appropriation bonds, certificates of participation and moral obligation bonds? Several states and many municipalities of size issue this kind of debt. Payment of P&I is dependent on the willingness and ability of subsequent legislatures to make this non-mandatory payment. Bondholders are out of luck and have no redress in court if the appropriation is not made.
If the above does not sound like debt to readers, you are correct and that is why states and localities can issue them. They are not illegal because the bonds don't constitute debt within the meaning of any statutory or constitutional provision. Let the buyer beware applies.
At the local level, these bonds have a terrible record, being central to nearly every municipal bankruptcy going back to and including Orange County, CA optional pay pension-funding bonds.
They don't exist anywhere else, except in the U.S. municipal bond market. There is approximately $650-$700 billion outstanding in the $3.5 trillion market or 20% mostly issued by states.
Puerto Rico has incurred through its Government Development Bank about $5 billion in optional pay debt who's voluntary P&I appropriations total about $550 million per year. The Commonwealth chose not to pay once. Their intentions going forward are not known, but making any further appropriations while payment of GO bonds is less than certain, would be one more of several legal issues if GO's go unpaid.
Purposeful circumnavigation of constitutional debt limits. That is what both of the aforementioned financing do. One not illegal, but risky and the other over the line, resulting in the need to levy an 11% sales tax.
Had the Commonwealth not had a financial crisis, the validity of transfers to COFINA would almost certainly not have been challenged. The same can be said about Washington's WPPSS or "WHOOPS" bonds had the local electric utilities in three states not been confronted with massive nuclear power plant cost overruns and a national swing against nuclear power.
It would indeed be unfortunate for the Commonwealth if it defaulted on its GOs only to find that a court has ordered full payment on GOs and an end to sales tax transfers to COFINA.
With a supporting opinion from the Commonwealth's Attorney General, the Governor could order a temporary suspension of COFINA payments and send the matter to Puerto Rico's highest court for a ruling. Given the leadership so far, that is unlikely but the best path to take for the populous, and restoration of the government's ability to borrow in its own name at reasonable rates.
Disclosure: I am/we are long COMMONWEALTH GO BONDS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.