Among Puerto Rico debt investigator’s recommendations: debt-issuance validations to regain investor confidence
SAN JUAN – As of May 3, 2017, Puerto Rico had about $74 billion of bond debt and $49 billion of unfunded pension liabilities. For an economy of Puerto Rico’s size, the burden of this debt has been catastrophic and begs a pressing question: How did it happen?
That is how a report in the investigation of the debt written by independent investigator Kobre & Kim begins before summarizing, in a 600-page report, the factors contributing to Puerto Rico’s debt, an effort that took nearly a year as well as interviews with over 100 witnesses.
When Puerto Rico’s Section 936 tax credit’s 10-year phaseout period ended in 2006, the island faced a declining population, increasing unemployment, mounting budgetary issues and escalating pension liabilities. Instead of implementing long-term plans to stimulate the Puerto Rico economy to balance the budget and to fund the Employees Retirement System, the report said the political branches and Government Development Bank (GDB) turned to the debt markets for quick fixes.
“The short-term fixes included, among others: the creation of the sales and use tax, a portion of which purportedly secured issuances by COFINA [Spanish acronym for Sales Tax Financing Corp.]; the entry into swap arrangements to generate cash to close budget gaps; an increase in deficit financing; and the issuance of Puerto Rico-Related Bonds that were purportedly secured by contributions to the Employees Retirement System,” the report reads.
With some of these structures, Puerto Rican entities incurred billions of dollars of liability, but did not include those amounts when calculating how close Puerto Rico was to reaching its constitutional debt limit.
“At times, in the absence of certain regulations…underwriters sold the Puerto Rico-Related Bonds through Local (Closed End Funds) in which only Puerto Rico investors purchased shares. Many of those Local CEFs were also managed by affiliates of the same investment banks that underwrote the Puerto Rico-Related Bonds in which the Local CEFs were invested,” the report reads.
Despite the consequences of the repeal of Section 936, the investigator said it found no evidence to support that reinstating the incentives would help improve the island’s current circumstances.
“As the Puerto Rico-Related Entities amassed unsustainable levels of debt, the Credit rating agencies [CRAs] became increasingly concerned about the Puerto Rico-Related Entities’ perpetual reliance on support from Puerto Rico and GDB, among other factors. The CRAs ultimately implemented a series of credit rating downgrades for Puerto Rico-Related Bonds at various points between 2012 and 2014, with most of those bonds reaching ‘junk’ status between February and June of 2014,” the report recalls. Many have since sought bankruptcy under Title III of the Puerto Rico Oversight, Management and Economic Stability Act (Promesa).
The report offers recommendations “for the people of Puerto Rico, and the policymakers who represent them, to consider in making sure they never have to go through all this again,” the report’s executive summary reads.
FOMB Final Investigative Report Kobre & Kim 20180820 (Text)
One of the findings noted that the GDB’s dual role as fiscal agent and lender affected its decisions, such as to lend money to the debt issuers “for deficit financing, or as alternatives to fiscally responsible measures that would have upset voters (such as a deeply imperfect substitute for raising water and electricity rates), without applying stricter credit standards or holding the Puerto Rico-Related Entities more accountable for failures to satisfy those obligations when they came due.”
The bank also approved new debt issuances for the purpose of “scooping and tossing” older obligations or “as an alternative to forcing the Puerto Rico entities to implement measures that would have made them less dependent.”
Regarding its summary for Puerto Rico’s public utilities, the investigator found that politics at the Puerto Rico Electric Power Authority (Prepa) affected its rates, keeping them high but “insufficient” to cover operational expenses and capital improvement projects.
“To compensate for the suppressed base rate, PREPA became dependent on short-term liquidity injections from GDB, with its principal means of repayment being the issuance of bonds. Based on our review of the evidence, we attribute this to a lack of political will to raise Prepa’s base rate; politically-induced obstacles to reducing the power rate by converting Prepa’s generation from oil to natural gas; and politically-sanctioned subsidies that reduced Prepa’s collected revenues,” the report reads.
Meanwhile, despite a “lack of political will” to raise rates at the Puerto Rico Aqueduct and Sewer Authority (Prasa), the market “ultimately forced” it to do so in 2008 and 2013.
“The evidence also reflects that neither GDB, in its capacity as fiscal agent, nor the underwriters of the Public Utilities’ bonds monitored the Public Utilities’ actual use of proceeds in relation to the represented uses identified in relevant offering documents. In part for this reason, we worked with a financial advisory firm to analyze PREPA’s bond issuances between 2010 and 2013. That analysis identified a difference of several hundred million dollars between proceeds from those issuances earmarked for PREPA’s Construction Fund, on the one hand, and reported uses of funds for construction-related projects and changes in restricted cash accounts for such uses, on the other hand,” Kobre & Kim wrote.
The investigator recommends that if the government opts to keep its public utilities, their boards should have a greater mix of governor-appointed and independent members serving “longer and staggered terms across administrations.” Audit committees should be created and the contribution in lieu of taxes arrangement with cities eliminated, among other changes.
The report did not find evidence that Cofina was created to evade the constitutional debt limit but to help solve Puerto Rico’s deficit issues.
“Over time, however, COFINA became a comparatively accessible source of liquidity that staved off the need for Puerto Rico to find a more permanent solution to its financial problems. And, there were insufficient checks and balances to encourage fiscal discipline or to counterweigh the expansion of uses for COFINA funds,” the report said.
If Puerto Rico were to issue debt through a tax-securitization structure in the future, the report recommends “implementing measures that are designed to operate as meaningful checks on the use and accumulation of that debt,” including amending the Constitution “so this type of debt counts toward the Constitutional Debt Limit calculation.”
Regarding the Employees Retirement System, the report questioned its decision to issue some $3 billion in pension obligation bonds in 2008 but found no evidence to claims there was a breach of fiduciary duty in the decision even though payments on the bonds would reduce contributions to ERS for 50 years. The securitization of the ERS payments was done because it did not require legislative approval.
The independent investigator criticized Puerto Rico’s budgeting, external reporting and accounting functions.
“Among other things, Puerto Rico failed to develop budgets based on accurate growth and revenue estimates, to which it could adhere; develop the infrastructure and resources it needed to support efficient accounting functions; and optimize its use of independent auditors. This often caused Puerto Rico’s external financial reports to be late, which, in turn, interfered with the ability of interested parties to acquire sufficient transparency into matters that concerned, or were otherwise intertwined with, Puerto Rico’s fiscal health,” the report said, while adding several recommendations including continuing to transition budgeting to generally accepted accounting principles, or GAAP.
The investigator examined the calculation of the constitutional debt limit and the historical processes and procedures established to calculate it.
“The evidence we reviewed supports the conclusion that Puerto Rico employed a reasonably robust process for these Debt Limit Calculations. And we did not find any evidence that Puerto Rico’s government personnel thought Puerto Rico misinterpreted the relevant constitutional provision or calculated the debt inaccurately.
“Nevertheless, in light of Puerto Rico’s debt crisis, Puerto Rico should consider whether it may be worthwhile for its judiciary to review the meaning of Section 2 of Article VI of the Puerto Rico Constitution, as well as the methods pursuant to which Puerto Rico determines the types of debt servicing payments to be included within the debt limit calculation. Significantly, the Constitutional Debt Limit did not prevent the issuance of legal, but ultimately unsustainable amounts of public debt,” the report said.
On the subject of issuance of bonds, the report fell hard on credit rating agencies and the processes to determine ratings.
“Because of the significance of credit ratings to certain types of investors, it is likely that the assignment of investment-grade credit ratings during the Relevant Period made Puerto Rico-Related Bonds appear more attractive to certain investors. But we cannot conclude that those credit ratings were a significant cause of Puerto Rico’s fiscal crisis. Still, there were vulnerabilities in the processes, procedures, and criteria that the CRAs applied. In the specific context of Puerto Rico-Related Bonds during the Relevant Period, the Issuers had too much power to frame the CRAs’ analysis, and the criteria that the CRAs applied,” the report said.
Regarding the Selling Practices for Puerto Rico-Related Bonds, the report said the triple tax exempt treatment given to Puerto Rico bonds fueled investor appetite. For that reason, the investigator encouraged lawmakers to consider reserving triple tax-exempt status for only the sub-set of bonds that comply with Section 103 of the Tax Code.
The report said it could not conclude, based on the evidence, that the flow of certain employees and officials between GDB and the private-sector violated any applicable ethics laws.
“Instead, the evidence we reviewed reflected that the Puerto Rico officials we studied generally either complied with applicable screening and disclosure requirements, or voluntarily sought legal opinions to bless their acceptance of private sector employment opportunities before they accepted them,” the report said. Several Financial Oversight and Management Board members have been criticized over their links to the GDB and private banks.
The report, however, recommends requiring GDB’s “successor as fiscal agent to establish an agency-level ethics committee that executes and documents the functions that the Government Ethics Act requires,” and provides formal confirmation of those functions to the Office of Government Ethics regularly.
Regarding the issuers’ use of interest rate swaps, the investigator said the regulatory landscape has evolved since the issuers entered in swap transactions but nonetheless recommended amending Act 39 so it applies to issuers other than merely Puerto Rico and the Public Buildings Authority.
As for the island’s “lack of a clear mechanism for validating” Puerto Rico-related bonds before they are issued, the report says the “litigation that followed the debt crisis” demonstrated that a clear avenue for judicial review, “in the form of a bond validation statute that would have required Puerto Rico-Related Entities to obtain judicial validation” of the issuance intended, “before going to market,” would have been beneficial.
“Adopting that type of statute now could help Puerto Rico to regain public confidence going forward, and thus to increase investor demand for future” bond issuances, the report recommends.