Lawless: Credit-Rating Agencies, Banks Conspire to Defraud Prepa Bondholders
Government officials, in apparent collusion with large banks and credit-rating agencies, worked together to engage in “massive fraud” at the Puerto Rico Electric Power Authority (Prepa) that contributed to the island’s financial crisis, a former senior banker has charged.
During a recent presentation in New York, of which Caribbean Business received a copy, Richard Lawless explained how banks, the government of Puerto Rico and credit-rating agencies worked together to cause the loss of more than $36 billion to bondholders who were forced to sell after Puerto Rico’s bonds lost value.
Lawless is the CEO of Commercial Solar Power Inc. (CSP), a company that was “forced” into bankruptcy by what he called Prepa’s “bizarre behavior,” which canceled renewable energy contracts with the firm a few years ago.
To understand what happened at Prepa, Lawless, who worked for more than 25 years in the banking industry, said people must understand that without the direct participation of credit-rating agencies, whose business is to sell debt ratings for a profit, Puerto Rico would not have been able to sell debt. He noted that selling bonds is a major profit center for banks too.
“The bond issuers can never repay the bondholders from their operating income, so they need to bring in more investors, which generates more rating purchases and sales fees for banks,” he explained, pointing to the role credit-rating agencies played in the 2007-2008 financial crisis by selling “fraudulent ratings” that allowed banks to sell mislabeled troubled debt as a safe investment.
CSP had no initial concerns about Prepa as it had a BBB+ investment-grade rating. Lawless said the company chose Prepa because it relied heavily on oil and had obsolete equipment, which made it the perfect client. CSP, however, lost $1.5 billion in contracts in renewable energy projects. He was asked to do a forensic investigation into the event and found—after analyzing Prepa reports from 2007 to 2014—that credit-rating agencies gave Prepa investment-grade ratings despite financial information from the utility itself that pointed otherwise.
“Credit-rating agencies have strict policies and procedures. It would be impossible for them to all miss the same critical underwriting issues without some form of collusion,” he said.
Banks, however, also didn’t do a thorough job examining Prepa.
When a person applies for a small loan, the bank assigns it to an official for examination, but when an agency applies for billions of dollars in loans, the bank assigns a team of highly educated individuals and underwriters to review the request, which goes from committee to committee. For bond issues, there is generally a lead bank and several junior banks, as well as the credit-rating agencies examining the transaction.
They all look at three basic underwriting criteria, which are cash flow, collateral and character of the issuer. The industry standard for bond issues, he said, is a ratio coverage of 1.2 to 1. In Prepa’s case, the bond offerings had a ratio of 1.38 to 1.
“As you read, you see the accountants used hundreds of millions per year in income that the utility never collected. In fact, Prepa had not collected that income for almost a decade,” he expressed. Lawless was referring to almost $1 billion in utility bills owed by agencies. “If you take this phantom income out, bond-payment coverage drops to about 0.82,” he added.
Lawless said that in the reports he examined, bond coverage, in reality, ranged from 0.62 to 0.82. He said it was a violation of the law by the accountants to include uncollected income as part of the debt coverage. “In no case could Prepa make any of those bond payments from normal business operations. Yet all the bonds were given good ratings,” he commented.
The banking executive also questioned why credit-rating agencies gave Prepa an investment-grade rating when their reports said the utility had $1.2 billion in accounts receivables, but $1.7 billion in unfunded liabilities. He also said every bond offering issued by Prepa includes money for upgrades that ranged from $300,000 to $500,000. “Remarkably, the money disappears and the upgrades were never done. A simple review of the bond offerings often reflects money being used for the same things from year to year,” he observed.
Lawless said he also looked at other Puerto Rico entities and found that some “are even in worse shape than Prepa,” but they too had received investment-grade ratings. He pulled bond issues from Chicago, Connecticut, California and New York and found the practice appears to be widespread.
Lawless referred his findings to the Federal Bureau of Investigation, or FBI, and the U.S. Attorney’s Office. He also filed a whistleblower report with the Securities & Exchange Commission and with the Internal Revenue Service. Prepa officials recently confirmed that three of the utility’s bond issues were being investigated.
During a recent P.R. Senate hearing into fraudulent oil purchases at Prepa, some utility officials acknowledged that since 2010, the utility was virtually insolvent. The financial reports from Prepa also showed that the utility had been burning sludge oil instead of No. 2 fuel oil. “I checked the oil-purchases account and it was clear they were paying for high-grade oil, but taking deliveries for sludge oil,” Lawless said. The utility, as a matter of fact, is in court fighting a Racketeer-Influenced & Corrupt Organizations Act (RICO Act) class-action lawsuit amid claims it overcharged customers to pay for cheap oil.