The government of Puerto Rico recently announced it had reached a settlement with Government Development Bank (GDB) bond and loan creditors - this is the latest example of misappropriation of central government funds.
The approximately $5 billion in bonds, notes, and loans being settled by the now defunct GDB are appropriation (optional pay) debts. On this type of "debt" the bondholder has no legal right or standing to demand payment or settlements.
Nonetheless those creditors were offered about 50 cents on the dollar subject to Title III court approval. Up until this development the bonds traded between 5 and 8 cents on the dollar. So, what's up?
In the Detroit bankruptcy, in essentially the same situation, Bankruptcy Judge Rhodes blocked the initial settlement made by the city on its appropriation bonds (certificates of participation), as much too high (generous).
They were settled by the Court at 13 cents on the dollar, versus zero, only because the certificates were additionally secured by a security interest in a gaming tax that was sufficient to pay 13 cents on the dollar.
How Bankruptcy Judge Swain presiding over the settlement in Puerto Rico rules on this matter where both parties are colluding to provide unlawful recoveries at the expense of Island residents, as was tried in Detroit, will be telling.
For more information on appropriation bonds Click Here. This form of lending instrument exists nowhere other than the U.S. municipal bond market.
The proposed settlement with the GDB is an example of the Government's longstanding policy set by the former Governor Padilla when he announced, "we cannot pay our debts and that all creditors, including constitutional bond investors must share the burden".
He may have just as well said: "I do not want a simple restoration of the power to grant Chapter 9 bankruptcy protection for Commonwealth corporations and municipalities, which we had up to 1984, but which was inexplicably lost when the Bankruptcy Act was amended that year."
Instead, I want special bankruptcy protection that includes the power to include constitutional direct debt (Commonwealth general obligation bonds) in bankruptcy. That's because we do not have enough money to pay the P&I on GOB's, Corporación del Fondo de Interés Apremiante - COFINA sales tax bonds, a Commonwealth corporation, (never validated in court) and optional pay appropriation debt (issued by the GDB and its many shell corporations and held, for the most part, by institutional investors and commercial banks).
Governor Padilla got what he wanted in the PROMESA Act. PRGOB's were put into default the day after the Act's litigation freeze took effect. A fait accompli whose timing was perfect.
The Root of the Problem
The biggest roadblock to passage of PROMESA was whether to include Commonwealth constitutional debt. A question that was quickly forgotten after passage of the PROMESA Act, which became law at the height of the last Presidential election when the then Governor and U.S. Treasury Secretary were vocal in their support.
Does Congress have the power to establish a new special bankruptcy court to write down direct debt of a constitutional entity, one of fifty-one comprising the United States? The constitutions of each were approved by Congress in 1952 with respect to the Commonwealth.
Put another way, does the plenary or absolute power that Congress holds over its Territories supersede or is it subordinate to constitutional rights of Commonwealth residents and U.S. citizens under the U.S. Constitution? Specifically, due process - the taking of property without due process.
My guess is that constitutional bond investors now in litigation have determined that a constitutional challenge is not necessary now. However, at any time these investors may split into two groups with one pursuing the existing claim and the other pursuing the constitutional question, simultaneously until one succeeds.
Assuming constitutional rights prevail, in Title III or Supreme Court, cleaving direct constitutional debt (GOB's) from PROMESA and its special bankruptcy court would not directly cure the current GOB default. But it would be the first step toward full restitution of P&I and market access for the Commonwealth.
That would leave the PROMESA control board and its court with only the debt of the Commonwealth's corporations to write down. Plus, the central government's pension obligations, which are not general obligations as they are in several states, but must be funded to a sustainable level in any event.
This brings up the issue of: 'what a piece of paper says versus what is economically possible and the greedy investors who demand full payment regardless of economic and social consequences.'
I would readily agree. If total GOB's outstanding equaled $13 billion, plus the $18 billion in COFINA bonds, or $31 billion in total, the constitutional promise would be broken because the money is just not there when public health and safety are considered.
But this is not the case in Puerto Rico. Most investors would not buy PRGOB's without a reasonable and constitutionally proscribed debt limit, including myself.
The Commonwealth's Constitution simply does not authorize the issuance of revenue bonds secured by or payable from general taxation (principally sales and income taxes), which by law constitutes general fund revenues.
Those revenues are pledged to payment of Commonwealth GOB's and Guaranteed bonds. This is the reason why the government did not seek COFINA bond validation for it would expose special interest from massive legal liability. For additional information on COFINA and its bonds Click Here.
Underwriters and law firms acted recklessly and possibly fraudulently in underwriting and distributing COFINA bonds. So did the Puerto Rico's government, but those officials are immune from liability, other than overt criminal acts.
If held unconstitutional, the settlements would be a multiple of those now being paid. Settlements with senior and subordinated bond holders would approximate 50% or about $9 billion in funds.
A deserved windfall for residents who should not pay one dime on COFINA debt. That would provide funds for pensions and clear the way for re-establishing limited market access with PRGOB's, which by then would be the only remaining debt payable by the central government.
At 13.5% of the 15% constitutional debt limit, the government would have some bonding capacity remaining for capital improvements. Chapter 9 would have sufficed. PROMESA is a mistake, making a mockery of 100 years of public finance law, two constitutions and generally accepted governmental accounting standards or GASB.
All to protect bankers and attorneys from a massive and well deserved legal liability. The intended losers are taxpayers, GOB holders, and the government who chose default on constitution debt when it was not necessary.
A state or commonwealth cannot create a corporation (COFINA) to issue revenue bonds secured by or payable from general state taxation (sales and income taxes) when the sovereign, under its constitution, cannot. By law, general taxation constitutes general fund revenues of a State or Commonwealth.
The issuance of COFINA bonds was possible only by breaking a Commonwealth constitutional pledge. The same would apply to the 46 states whose constitutions also do not authorize revenue bonds secured by general fund taxes.
Four state constitutions do authorize state revenue bonds secured by general fund taxes: Illinois; New Mexico; and two other states dependent on mining/extraction, like New Mexico.
For that reason, the GOB versus COFINA dispute is not even hypothetically possible. Yet there it is. A blatant illegal circumnavigation of Puerto Rico's constitutional bond issuance limit, which otherwise has never been broken.
Do not point to NY State and the copious amounts of sales and income tax bonds outstanding issued by various state corporation. They are in fact appropriation optional pay bonds, not in any way secured by any lien on general fund taxation.
Optional pay U.S. state appropriation bonds outstanding greatly exceed the amount of state general obligations outstanding. This is the municipal bond market's dirty little secret.
None are in immediate risk, but it would be nice to get a clear message that should a state fall into a financial situation such as Puerto Rico's, at least we should know that state GOB's get paid first.
I ask: What is the point of a constitutional limit on debt if the legislature can legally create a corporation whose revenue bonds are secured by liens on general fund taxes. Unlike GOB's, COFINA bonds are not limited by permitted purpose or issuance amount, only by market acceptance.
What the Act and Island government are trying to get away with is akin to passage of a Congressional Act creating a bankruptcy court for one, but not all, U.S. states; or extending Chapter 9 to all states. Not illegal to pass but impossible to defend in court based on separation of powers doctrine.
The PROMESA Act's special bankruptcy court's charter conveniently does not include determining the legality of any covered debt specified in the Act.
The Board accepts all their numbers from the central government, which has not been able to produce audited financial statements since 2014.
The current Governor Ricardo Rossello and former Governor Padilla each blocked or suspended legislatively approved investigations into the legality of Commonwealth corporation bonds.
Unlike all state corporation and local bond issues, including Puerto Rico's, contain no reference to Chapter 9, or any bankruptcy court, in the risk disclosures for any state or Commonwealth GOB issue ever sold.
Just how obvious does all this have to be?
Why does the Commonwealth's 10.5% sales tax exclude motor vehicle sales?
Commonwealth estimated full value of taxable real estate is approximately $80 billion. Municipal property tax rates are extremely low, based on 1957 construction costs. The central government levies a property tax that yields a paltry $100 million per year.
By law, if that matters any more in Puerto Rico, that property tax can only be used to pay P&I on constitutional debt and may be levied in an amount sufficient to pay all P&I on constitutional GOB's. The tax has not been increased.
Should property owners be held completely harmless for electing a string irresponsible law-breaking administrations?
The Title III Court Judge Swain may be able order payment of only legal and enforceable debts, making a constitutional challenge to PROMESA moot. For the Islands population, its government, holders of its legitimate debt and the municipal bond market, let's hope for that outcome.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.