Whether Congress Acts On Puerto Rico's Financial Crisis Or Does Not, The U.S. Supreme Court Will Likely Determine The Fate Of Puerto Rico's Investors.

by: Carl Dincesen


The Fourteenth Amendment reads, in part, that no state shall "deprive any person of life, liberty, or property, without due process of law." This applies to Federal, state, and local.

Puerto Rico circumnavigated its constitutional debt limit by issuing massive amounts of extra constitutional appropriation bonds and later highly suspect COFINA bonds. In aggregate, putting GO bond investors at risk.

COFINA Corporation is repository of waste consisting of refunded extra-constitutional debt and operating deficits.

A financial rehabilitation law expected to be enacted by Congress for Puerto Rico is necessary. Nevertheless, extending bankruptcy protection to Puerto Rico's central government is not only unnecessary, it would constitute a violation of the due process clause of the U.S. Constitution.

Congress approved Puerto Rico's Constitution soon after it was approved by the Island's Legislature in 1952.

Because of that, Congress cannot retroactively suspend or substitute due process for a kind of entity that has never before been subject to court sanctioned financial reorganization.

The Fourteenth Amendment reads, in part, that no state shall "deprive any person of life, liberty, or property, without due process of law." This applies to Federal, state, local governments, and to Puerto Rico. The Due Process Clause of the Fifth Amendment applies to the Federal Government, whereas the contract clause does not.

Due Process Clause and the equal protection guarantee of the Fourteenth Amendment were expressly extended to Puerto Rico by the U.S. Supreme court in the 1970's.

In other words, due process for Commonwealth general obligation investors is timely payment in full. Importantly, default isn't necessary from a financial feasibility/public good point of view. In other words, the principal and interest payments on Commonwealth GO and Guaranteed debt totals less than the maximum 15% percent P&I to revenue ratio specified in its Constitution. Further, that is the percent of general fund revenue the central government now says it can afford to pay in P&I on an ongoing basis.

That percentage is a reasonable number and one that GO bond investors relied upon to protect against over issuance potentially so great as to make repayment impractical.

Nonetheless, Puerto Rico circumnavigated its constitutional debt limit by issuing massive amounts of extra constitutional appropriation bonds and later COFINA bonds. In aggregate, putting GO bond investors at risk, and as well, any hope of Puerto Rico's ability to borrow, without penalty, in its own name for many years.

Big money and Puerto Rico's government want to drag the GO's into the recovery pot to increase the amount of recovery money available for $18 billion COFINA sales tax bonds and a large but not fully disclosed amount of extra constitutional optional pay "debt".

The latter are merely payable from, not secured by, annual appropriations made by subsequent legislatures at their option. If payments were mandatory i.e., binding on subsequent legislatures, they would constitute alternate debt which is prohibited under the Constitutions' of Puerto Rico and, for instance, the State New York.

New York State has authorized the issuance of copious amounts sales tax and income tax bonds by five different state corporations ranging from the New York State Thruway Authority to the Dormitory Authority.

In the final analysis these bonds are no different than, for instance, NYS Metropolitan Transportation Authority Service Contract bonds. They are, like many others, all appropriation bonds for reasons stated above.

Ironically, the device that saved New York City from a likely bankruptcy was the original appropriation or moral obligation bond. Many, like the original Municipal Assistance Corporation for the City of New York where festooned with representations of pledges of state or municipal-wide taxes.

None of that matters unless and until the central government makes a voluntary appropriation. Hundreds of billion dollars have been sold on the premise that a failure to appropriate would severely damage credit standing. But, if an issuer has no credit standing there is no reason to pay, particularly when doing so endangers payment of enforceable constitutional debt. Politics appears to be overshadowing the legal issues in Puerto Rico.

COFINA Corporation background - A repository of waste consisting of refunded extra-constitutional debt and operating deficits.

By 2006, the municipal market was telling the Commonwealth that it had little appetite for any more appropriation bonds, and then aptly referred to as extra-constitutional debt, optionally payable by each subsequent legislature. The amount outstanding was $16.9 billion.

In that same year, legislative Act 91, creating COFINA, was passed into law for the sole purpose of refinancing outstanding extra constitutional (appropriation) debt in response to the market's near refusal to buy any more.

COFINA sales tax bonds were first sold in 2007. Today there are $18 billion of COFINA senior and subordinate sales tax bonds outstanding, including accretion on zero coupon bonds maturing out to 2057.

The Commonwealth was in a bind, having little access to the bond market. The amount needed could not be met with GO bonds due to the debt limit and the fact that GO's can only be issued for infrastructure, not for refinancing extra constitutional debt.

Legislation in 2009 and 2013 expanded the purposes for which COFINA bonds could be issued to include covering operating deficits in fiscal years 2009 through 2015.

Why hadn't someone thought of this magic solution before? Probably because Puerto Rico's Constitution and those of nearly all of the U.S. states have no provision for the issuance of debt secured by general fund revenue other than general obligation bonds. That Issuance is always subject to voter approval or to a proscribed P&I to general fund revenue limit.

A challenge in court contesting the validity of COFINA bonds on Commonwealth constitutional grounds would most certainly succeed; thus far, the only opinion has come from an acting attorney general.

This is a never before seen state or commonwealth bond structure with a purported lien and security interest on general fund sales tax revenue. In creating COFINA the Commonwealth did nothing more than forestall the current financial crisis by about six years.

Every offering statement of COFINA bonds disclosed the risk of non-payment, should a court find the transfer of general fund sales tax revenue to COFINA unconstitutional, invalidating the bonds

Extra constitutional appropriation debt stands at $6 billion plus and an undisclosed amount of inter-fund non-public borrowing between the Government Development Bank and the 15 other state appropriation backed corporations. The GDB controls all of these corporations and COFINA. GO and guaranteed bonds total $13 billion in par outstanding.

Commonwealth officials stated on April 10, 2016 that their latest debt reduction proposal "would lower the debt service-to-revenue ratio on tax-supported debt from 36 percent to 15 percent." While the 15 percent ratio still exceeds that of the most heavily indebted U.S. states, it is in line with Hawaii's 13%, the other island state.

Officials went on to say, "Importantly, the current proposal does not pick winners and losers among Puerto Rico's complex capital structure. Rather, it provides all creditors the opportunity and responsibility to participate in a consensual, negotiated solution to Puerto Rico's onerous debt burden." Legislation that exempts any particular class would serve as an inappropriate Congressional bail-out of specific classes of creditors."

How could making payments on bonds for which there is no legal obligation to pay be in the best interests of the people?

A financial control board modeled after the one imposed on the City of New York by the State is necessary. It was quite successful in changing the City's financial culture.

A negotiated solution to debt secured by general fund revenues is a fantasy. Negotiated debt relief is only possible with enterprise revenue bonds, like the $20 billion in Puerto Rico's water, sewer, and electric bonds whose payment rests solely on the sufficiency of customer charges and fees for service.

Chapter 9 is where unsecured contracts can be broken and obligations are written down, some special revenue secured debt, equivalent to collateral on corporate debt, exempt - negotiation isn't a principal part of the settlement process as approved by the Chapter 9 judge.

In conclusion, the to be determined control board would do well to include two respected and experienced bond counsels and forensic accounts experienced in governmental accounting standards. COFINA bonds were first issued with only an underwriters' counsel validity opinion.

The law is the fabric of the U.S. public finance market, much more so than non-governmental debt markets. What a municipal entity or state can and cannot do is dictated by law. My advice is follow the law, and do not invent something new or unique when it is not necessary.

The municipal market is the envy of the world, having international acceptance of federal, state, and municipal securities. Let's keep it that way.

Disclosure: I am/we are long COMMONWEALTH GO'S.

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.

Additional disclosure: SA Editor Michael Lipkin Asked that I shorten the title which i have done and resubmitting