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Specious legal arguments argue for zero recovery on allegedly invalid bonds versus serving the Commonwealth and its people.
We believe that the strategy adopted by the Financial Oversight and Management Board (the Board) for Puerto Rico and the Unsecured Creditors Committee (UCC) in seeking invalidation of certain bonds is fundamentally flawed and works against the interests of the Commonwealth and its people. Instead of the intense litigation that was initiated, we believe that a swift resolution through mediation would have benefited all stakeholders. We examine below the flaws of the invalidation litigation and the Board’s broader strategy.
In January 2019, the UCC and the Board put forth the argument that certain General Obligations (GO) bonds issued by the Commonwealth of Puerto Rico are invalid on a number of theories, the most salient of which is that the issuances in 2012 and thereafter breached the Puerto Rico constitutional debt limit. The UCC and a number of bondholders later argued that, on the same basis, some of the prior GO issuances and bonds issued by the Public Buildings Authority (PBA), and guaranteed, by the Commonwealth could be invalid as well.
We believe that the invalidation argument suffers from key fallacies. First, the documentation (including related legal opinions) and the issuer’s long-standing practice of calculating the debt limit confirmed that these issuances were within the constitutional debt limit. Second, the Debt Investigation Report, prepared by Kobre & Kim LLP, which comprehensively audited the debt issuances, did not conclude that the debt limit had been breached by GO or PBA issuances. Third, we believe that the arguments presented by the Board and, in particular, the UCC, are overreaching, as is the variation offered by the Quinn Emanuel Urquhart & Sullivan group of GO bondholders. None of the arguments, in our opinion, relies on precedent on point.
When coupled with its ultra-conservative assumption in the fiscal plan, we think that the Board has reduced the chances of a negotiated outcome and is instead pushing for a purely litigated outcome. The practical consequence of this being a poisoned consensual well and the profound resentment of the Commonwealth and its creditors. We believe that the legal consequence will be an intensification of litigation (between creditors and the Board joined by opportunists and among creditors) and hence a quest for higher recoveries. The crowd of bondholder groups and legal advisors involved, which is a direct result of the Board’s (successful) divide and (not so successful) conquer strategy, will generate additional litigation, which we think the Board has misread as generating upside only.
The intricacies of Commonwealth public debt are much more significant than COFINA 1, a GDB 2, or a PREPA 3, namely because it covers a wide variety of claims and stakeholders which makes the litigation that is being filed risky in terms of (1) opening a pandora’s box with no predictable outcome, (2) an inability to walk back some of the legal actions that have been initiated, and (3) risk of entrenchment of various creditors in litigation which is harder to reverse over time.
Impairment of creditor rights and future market access
The Commonwealth’s GO is its flagship bond and a standard type of bond in municipalities. Going forward, we believe that the market will no longer trust a plain vanilla GO bond, which will result in either higher yields or secured revenue bond structures that are more complex, constrain the flexibility of the Commonwealth in the management of its resources, and might not be as favorably absorbed by the municipal bond market. Not only does the litigation create unpredictability and compromise future issuances, current bond prices indicate that the bigger picture of seniority of GO bonds within Commonwealth public debt has been lost.
The real impact of invalidation
A successful invalidation would have (1) limited impact as, at most, the outstanding amount of challenged bonds would be reduced to bring it within the debt limit (contrary to the Board and UCC’s assertion that it should be invalidated in full), and (2) no benefit for the Commonwealth because the Board’s theory is to offer a pre-set amount to GO bondholders: it increases the recovery of certain bondholders to entice their consent to a plan of adjustment structured at the expense of other GO bondholders – a zero sum game for the Commonwealth and its people.
GO bondholders would have more leverage on the Commonwealth in the absence of the PROMESA Title III process 4 (i.e., similar to a U.S. Bankruptcy Code Chapter 9) and, as a corollary, the Commonwealth and its people would be vulnerable to the discomforts of attachments of assets (including its large cash balances) and the continued burden of contractual debt service, without any clear path to obtain concessions from creditors. Why should GO bondholders worry if the Title III process is dismissed by the Courts as a result of a prolonged impasse? Those who should worry most are not GO bondholders but pensioners and holders of structurally creative or bespoke claims that cannot rely on clear constitutional priorities.
Contrary to any other restructuring we have seen, there appears to be no solvency or liquidity problem considering Puerto Rico’s increasing economic performance, cash balance, and possible improvement in governance thanks to the Board’s vigilance. As a result, we believe the need for haircuts or other concessions from creditors will wane with the passage of time.
Increased costs and expenses
The litigation that has already resulted from the invalidation action, and the ancillary litigation that will be needed to correct its wrongs, is a considerable waste of judicial resources and taxpayer money.
As in COFINA (where the circumvention of the Puerto Rico Constitutional debt limit through a securitization of sale and use tax revenues was questioned), the most likely outcome is a settlement of the invalidation action at a recovery level for bondholders that indicates that this action was meritless. The Board’s actions will likely make it more expensive to get to a settlement with creditors because bondholders look to the higher of the trading price, and the price that creditors assess based on their legal rights. In other words, it is not so much the fall in price of the challenged GO bonds that matters; it is the increase in price of unchallenged GO bonds and PBA bonds that has raised the threshold for recoveries to be offered in a confirmable plan of adjustment.
It may be that this is needed for local or Federal political consumption, but it does not pass a cost-benefit test. The quest for higher recoveries by creditors and the additional and avoidable costs and expenses – included or not in the professional fees of the Board, the AAFAF 5, and the UCC, to the tune of USD 1.1 billion over five years – will ultimately be borne by the Puerto Rican people.
The better agenda
The Board will likely attempt to craft a plan of adjustment that takes advantage of the differences in price of GO bonds. We think that this attempt and the invalidation litigation will ultimately fail, and all GO holders will be entitled to the same plan consideration. Instead, the Board should revert to a consensual restructuring through mediation and move the debate to the proper place, i.e., the structure of recovery package (for example, a growth instrument as a component thereof) that makes the most effective use of the sizeable cash balances and incentivizes the Commonwealth to deliver on reforms for its people while offering an acceptable recovery to creditors to ensure a fast-track debt restructuring and regain market access at competitive yields. We believe that the recent economic recovery and cash balance levels would make that a considerably easier conversation to be had.
Finally, we believe that the Board is right when it claims that it now has a unique opportunity to fix Puerto Rico. Under PROMESA, the Board has not been designed to be a permanent institution, but it is instead mandated to do a rapid and deep fix of Puerto Rico’s fiscal and structural situation. That said, a significant level of uncertainty looms ahead for Puerto Rico, including a Presidential election, a PR gubernatorial election, a Congressional committee looking to possibly revise PROMESA; improving economic performance of PR reducing urgency for fiscal and structural measures, so why risk the current stable backdrop?
1 Puerto Rico’s Sales Tax Financing Corporation, a government-owned corporation.↩
2 The Government and Development Bank for Puerto Rico has been liquidated and was the first instrumentality whose debt was restructured under the 2016 Puerto Rico Oversight, Management and Economic Stability Act (PROMESA)↩
3 Puerto Rico Electric Power Authority, the Puerto Rico power utility company.↩
4 Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA), a US federal law establishing, among other features, an oversight board and process for restructuring debt to combat the Puerto Rican government debt crisis.↩
5 Puerto Rico Fiscal Agency and Financial Advisory Authority, a group of government-owned corporations that manage all aspects of financing for the executive branch of the government of Puerto Rico.↩