Puerto Rico's COFINA Bonds, Road Block To Equitable Settlements - Residents And GO Investors May End Up Paying Unnecessarily

by: Carl Dincesen

Summary

The Puerto Rico Financial Control Board established by Congress is falling far short of initial expectations. The baby is being thrown out with the bath water.

Contrary to expectations, the legitimacy of the Island’s overwhelming debt should, but is not, being addressed by the Control Board.

That fact, absent court intervention, will most certainly result in a political whitewash at the expense of the Island’s residents and investors holding its constitutional debt.

It took a while to figure out what category COFINA bonds belonged to. I ended up with a new category: rogue object in the U.S. public finance solar system - alien and defective.

The category in which it belongs will determine whether investment bankers and attorneys who underwrote and distributed COFINA bonds will be shielded from the massive financial liability for having sold bonds that have been deemed illegal and not payable. Or will residents and constitutional bond-holders pay for COFINA bonds, even in reduced amount? COFINA bonds have not been validated in a court of law.

To prove that point or at least raise doubts and questions among non-believers, consider the following bond counsel opinion and other risk disclosures taken from a 2009 official statement for the sale of COFINA sales tax bonds.

I call it the Good, the Bad and the Ugly

All COFINA official statements covering each issue sold since inception in 2007 through its last issue in 2013 carry similar opinions and disclosures. The 2009 COFINA bond official statement is attached as supplemental information.

Let me ask one question in advance. Why hasn't the Commonwealth government challenged the constitutionality of Act 91 amended by Act 291 which created and funded COFINA? If successful, that would provide the government and residents with a recurring windfall of needed cash, about $800 million annually and increasing. The answer may surprise, but first:

The Good

"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 (Nixon Peabody) are of the opinion, under existing law, as follows:

3. The proceedings of the Corporation about 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 a legal, valid, binding, and enforceable obligation of the Corporation. "

"On the date of issuance of the Series 2009A Bonds, the Secretary of Justice of the Commonwealth (who acts as attorney general for the Commonwealth) will issue an opinion (the "2009 Opinion") opining that (NYSE:I) Act 91 and each of the statutes amending Act 91 were validly enacted by the Commonwealth and are in full force and effect, (ii) the Dedicated Sales Tax Fund, the funds on deposit therein and the Pledged Sales Tax do not constitute "available resources" of the Commonwealth for purposes of the Constitutional Debt Priority Provisions, and (NASDAQ:III) the Dedicated Sales Tax Fund, the funds on deposit therein and the Pledged Sales Tax are not available for use by the Secretary of the Treasury. On July 31, 2007, about the issuance of the initial series of Outstanding Senior Bonds, the prior Secretary of Justice issued an opinion (the "2007 Opinion") reaching substantially the same conclusion".

The Bad

"The Supreme Court of Puerto Rico has not addressed the constitutional issues covered in the 2009 Opinion and the 2007 Opinion and could reach a different conclusion. The Supreme Court of Puerto Rico, however, has consistently ruled that there is a presumption of constitutionality that attaches to every statute adopted by the Legislative Assembly and has further stated that opinions by the Secretary of Justice, although not binding, are entitled to persuasive weight. The Supreme Court of Puerto Rico has also stated that deference to the Legislative Assembly should be especially high in matters involving the use of public funds and the regulation of the economy, and that in these types of cases, the constitutionality of a statute will be upheld unless there is no rational relationship between the legislation and a legitimate government interest.

The opinions of Bond Counsel and Underwriters' Counsel described above expressly note that a court's decision regarding the matters upon which they are opining would be based on such court's own analysis and interpretation of the factual evidence before it and applicable legal principles. Thus, if a court reached a different result than that expressed in such opinions, such as that the exclusion of the Pledged Sales Tax from the definition of available resources for purposes, the Constitutional Debt Priority Provisions is unconstitutional, it would not necessarily constitute reversible error. Consequently, the opinions of Bond Counsel and Underwriters' Counsel described above are not a prediction of what a particular court (including any appellate court) that reached the issue on the merits would hold, but, instead, are the opinions of Bond Counsel and Underwriters' Counsel as to the proper result to be reached by a court applying existing legal rules to the facts properly found after appropriate briefing and argument and, in addition, are not a guarantee, warranty or representation, but rather reflect the informed professional judgment of Bond Counsel and Underwriters' Counsel as to specific questions of law".

The Ugly

"To the extent that a court determines that the Pledged Sales Tax constitutes "available resources" for purposes of the Constitutional Debt Priority Provisions, the Pledged Sales Tax may have to be applied to the payment of principal and interest on the Commonwealth's public debt before being used to pay principal of and interest on the Bonds, including the Series 2009A Bonds. Should such application be required, the ratings on the Bonds may be adversely affected"

The Supreme Court of Puerto Rico approved a 5.5% Island-wide general fund sales tax on November 11, 2006.

An amendment to Act 91, Act 291 that codified the amount of sales tax earmarked for COFINA and the mechanism designed to obtain the tax revenue from the treasury was approved after the sales tax legislation on December 26, 2006.

Neither Act 91 nor Act 291 291 were submitted to the Supreme Court for approval.

Puerto Rico's government has the authority to enact a retail sales tax, but does it have the constitutional authority to exclude all or a part of that tax from the Commonwealth's general fund, a tax that is a principal source for payment of constitutional debt?

Consider the following in addition to the above legal anomalies and related risk disclosures.

All U.S. states except four, including New Mexico and Illinois, are constitutionally prohibited from incurring direct debt other than GOs, which in all cases are subject to either a proscribed constitutional limit or public approval by majority vote. In addition, there are constitutional prescriptions for what bond proceeds may finance, mostly bricks, mortar, and highways and what proceeds may not finance, like operating deficits.

No U.S. state has ever deployed general fund sales or income taxes to secure debt of the state or a state corporation absent specific constitutional authorization to do so.

The Commonwealth stands alone among the 15 U.S. Territories in having a Constitution. One approved by Congress in 1952 and amended in 1960 to incorporate the 15% GO P&I limit on general fund revenue. GO and Guaranteed bond maximum annual P&I now equals 13.5% general fund revenues.

How did the Commonwealth accumulate so much more tax supported debt?

You might ask, how does a government with a strict constitutional limit on amount, kind of permitted debt, and purposes for which it may be incurred, end up with $18 billion, including accreted value of zero coupon bonds, of COFIN5A bonds issued for any purpose deemed appropriate by the legislature and governor?

That massive debt was issued over less than ten years. Bond proceeds were used to refund (replace) $10 billion of extraconstitutional appropriation bonds and fund $5 billion of general fund operating deficits, leaving approximately $5 billion of appropriation bonds outstanding today.

There is just one way to circumnavigate a state's limit without breaking sovereign constitutional law. Several U.S. States and the Commonwealth can and do authorize one or more of their corporations to issue appropriation backed bonds. States and the Commonwealth never issue this kind of obligation directly.

Appropriation bonds do not violate any law concerning issuance of governmental debt i.e., a multiyear contract binding subsequent legislatures to mandatory, not optional payment of P&I. Because the annual appropriation is optional, it does not constitute debt within the meaning of any constitutional or statutory provision of the States or Commonwealth of Puerto Rico. This is the wording found on the cover of official statements for every issue of appropriation bonds by state corporations, or local issuers.

The alternative is creating a problematic new security and issuing bonds without court validation of their legality. Only the Commonwealth has tried that because, by 2006, the market had little to no appetite for more appropriation debt with $16 billion outstanding and issued by a dozen Commonwealth corporations.

Those bonds are all payable in this same manner, from non-mandatory appropriations. The board of directors of every Commonwealth corporation that sells appropriation bonds consist of the Board of Directors of the Government Development Bank or GDB.

For that same group of issuers, we find that state corporations and local issuers always include a warning about Chapter 9 bankruptcy risk, whether currently authorized for the entity or not. At the same time, State and Commonwealth GO bond issues do not mention Chapter 9, because it does not apply.

Please see What are Appropriation Bonds & What Are General Obligation Bonds

Negotiation without extortion may not be possible.

Readers should understand that the central government's direct debt consists solely of GO and guarantee bonds, but the central government's general fund is not only paying constitutional bond P&I. It is also where voluntary appropriations are made to pay P&I on appropriation debt.

Failure to appropriate P&I on any or all of the issuer's bonds has left and will leave investors with no claim or basis to seek payment or any recovery from any court of law, as explained above and in the What Are Appropriation Bonds link.

In response to and in need of more borrowing capacity, the government created a new class of risk, different from GO and appropriation bonds, i.e., the COFINA Corporation with tremendous borrowing capacity that could be used to fund any purpose in any amount deemed appropriate by the Government, and that the market will accept.

The often quoted $70 billion in Commonwealth "debt" includes more than $20 billion in debt that is not directly related to claims for payment from the general fund taxation including:

  • PRASA and PREPA are the Commonwealth owned water and sewer, and electric enterprise utilities whose debt is secured solely by a lien on rates, charges, and fees for service. Both corporations will benefit from the protection afforded under the Chapter 9 equivalent under PROMESA,
  • all local government municipal bonds, and,
  • the few remaining state corporations that do not issue appropriation, AKA extraconstitutional debt, and together constitute less than 7% of total Commonwealth and public corporation debt. They are self-supporting like PREPA but do not appear to need the bankruptcy protection available under PROMESA.

That makes just three principal creditor classes: Constitutional bond investors, COFINA bond investors, and appropriation-backed bond investors where different corporation issuers and issues do not matter. All of them are paid on the same terms and conditions from one bucket, the Commonwealth's general fund.

Puerto Rico's debt is not nearly as complex as many would have us believe.

The law and numbers paint a simple picture of who and how much, if anything, each should get under the law with full consideration for the public good and promises made to public employees.

COFINA bondholders are victims of a sophisticated fraud. In the invalidation scenario, they will recover as much as or more than they would from a control board-accepted writedown. The public pays nothing towards invalid debt, the perpetrators do - all the bankers and law firms involved in underwriting and distribution of invalid and fraudulent bonds.

The liabilities would be massive with recoveries starting at 40% and up. Certainly, better than WPPS holders, a much less clear cut case. This powerful group will obviously do their utmost to avoid anything that tests the validity of Act 91/COFINA funding.

The above answers the question we started with. I hope you agree:

A successful COFINA challenge would provide the government and the people with a windfall of needed cash, about $800 million annually and increasing. That is the total amount of COFINA P&I due in 2017 as per the last issue of COFINA bonds in 2013.

The application of the new unencumbered general fund revenue is obvious - fund public employee pensions and start reducing the Island's 10.5% retail sales tax rate.

Disavowing all "debt" on which payment is optional and not legally enforceable (all appropriation bonds and notes) might be a good and obvious step that inexplicably has not been taken. The courts deal with legal obligations not moral obligations.

I predict that COFINA creditors will be quick to the negotiating table and to reach a deal, whereas constitutional bond investors will not. That may put constitutional investors in a position of being extorted by PROMESA's Control Board to accept a "negotiated" writedown.

The special bankruptcy court created by PROMESA is the last stop for any class of investor who does not reach consensual agreement. But a filed federal case contending supremacy of constitutional debt, Lex v. Padilla, could prevent that scenario, once the stay on litigation is lifted.

The current number of dollars available to the central government to pay its operating, maintenance and debt expenses is an economic reality that under certain extreme circumstances can trump statutes and constitutional law.

Fortunately, that is not the case in Puerto Rico, although that is the impression of most people given what the general press has reported. The sky in Puerto Rico is not falling, contrary to what the prior administration would have you believe.

The all-important numbers that support the above are:

There are two views held on the topic by a surprising number of informed people. One is that invalidation of such a large amount of debt would be a catastrophe, as did half the American public when Trump was elected President, but the sky did not fall.

The other is that invalidation would mess up the plans that some have to expand the COFINA securitization (sales tax) credit structure in order to finance ongoing needs - I presume for capital improvements.

Not much can be said for future financing plans that are built on questionable legality, absent a constitutional amendment.

More importantly, that position fails to understand that central governments like the States and Commonwealth cannot sustain debt levels that require more than 15% of total annual general taxation or general fund revenue, absent the ability to print money. The closest state is Hawaii, another island government, with direct debt taking about 11% of general taxation.

Commonwealth constitutional debt, which should be viewed as being in temporary default, takes 13.5% of general fund revenues. Puerto Rico cannot afford any combination of long-term debt that exceeds 15%.

The answer is anything but defaulting on GOs, not only because a Congressionally approved Constitution says so, but because they are affordable. The Commonwealth has played all the cards and will now have to live with limited GO borrowing capacity that will depend on general fund revenue growth.

Or special interests will prevail.

Disclosure: I am/we are long PRGOB'S.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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