Puerto Rico Debt Recycled?
Will the Financial Oversight & Management Board for Puerto Rico (FOMB) and the Unsecured Creditors Committee (UCC) successfully address a huge portion of the island’s debt by annulling about $6 billion in general-obligation (GO) bonds and $4 billion in Public Buildings Authority (PBA) bonds? There are no easy answers, but there is a precedent.
The process began late last year. On Dec. 21, the FOMB and UCC filed an adversary proceeding seeking to annul PBA leases because they were not rent payments, but rather financial transactions used to pay PBA bonds. The PBA is a government corporation that was created to issue bonds to finance the acquisition and construction of office space and other facilities used by government agencies. Currently, more than $4 billion in aggregate principal amount in PBA bonds remain outstanding.
Paying debt with rent
According to the adversary proceeding, the PBA entered into purported leases, pursuant to which it ostensibly leases PBA facilities to agencies. In reality, the FOMB and UCC say, the leases are not rental transactions designed to grant the government space, but rather are a vehicle for the commonwealth to repay the PBA bonds through the rent payments. Some 1,900 leases provide for the payment of about $401.6 million in annual rent, with an excess of $600 million in unpaid rent having accrued since the government filed for bankruptcy.
As a result of this changed focus, the Oversight Board and UCC are seeking a ruling, saying that because PBA leases are not true leases, but rather a disguised financial transaction, then PBA bondholders under Promesa and the Bankruptcy Code are not entitled to receive any rent payments from debtors. Such a relief is important for debtors to emerge from Title III bankruptcy.
Holders of PBA bonds have been alleging in court that the rent payments must be made because they are an administrative expense under the Bankruptcy Code. The holders of PBA bonds consist of a group of investment funds that include Fir Tree Partners, Candlewood Investment Group and IngleSea Capital LLC.
The attempt to annul the leases was followed by a Jan. 14 petition in which the FOMB, acting through its Special Claims Committee, and the UCC filed a request to invalidate $6 billion in GO bonds issued after March 2012 or, alternatively, to disallow the claims to the extent they include an unamortized original-issue discount. The FOMB and UCC are alleging the debt violated constitutional debt limits, which establish that debt service may not exceed 15 percent of average tax revenue over the past two years or the balanced budget clause of the Commonwealth Constitution.
PBA bonds part of debt limit
The proposed annulment of GO bonds covers two issuances made under former Gov. Luis Fortuño: one for $2.3 billion and another for $450 million. It also covers $3.5 billion in GO bonds issued in 2014 under the administration of former Gov. Alejandro García Padilla. The FOMB says the first two bond issuances are invalid when the debt from PBA bonds is considered in the calculation and the 2014 bond issue is invalid regardless. Therefore, the dispute will include a debate over whether PBA bonds should have been calculated as part of the debt limit, which according to the FOMB and UCC, was guaranteed by full faith and credit and should have been part of the calculation.
“Courts throughout the country have seen such public building authority structures for what they really are—transparent shams designed to circumvent constitutional debt limits,” the document says.
If the commonwealth succeeds in annulling the debt, it would be cut by nearly half the $13 billion GO debt.
Tied to all these transactions are government attempts to object to claims made by dozens of bondholders because their assertions are defective in some form. There is a difference between a repudiation of a debt, which is made when it is invalid, and the objection of a debt, which is mostly because it is the wrong amount or the debtor has already paid it.
Nilda González Cordero, a bankruptcy lawyer from Guaynabo, said that in her practice she has seen business clients in bankruptcy processes object to claims but noted that “it is a complicated process…. It is a different matter to engage in a controversy over the amount of the debt or to have interests reduced than to say, ‘take this away from me.’”
She declined to say whether the government would be successful in its endeavor because she has not studied the constitutional aspects of the dispute but noted that “Puerto Rico has not audited its debt and an audit could tell you if a debt was illegal.”
Did government officials know, or should they have known, that the bond iss
uances were illegal? What went wrong? The Kobre & Kim investigation report into the causes of the debt, published last year, said the government followed a robust process to determine constitutional debt limits, a process that included the Treasury secretary, Government Development Bank (GDB), bond counsel, underwriters’ counsel and the secretary of Justice. The latter issued an opinion in 2014 stating that bonds are valid commonwealth obligations. The problem the debt report asserts is the Justice secretary did not check debt-limit calculations and deferred those matters to the GDB.
Part of the problem was that Puerto Rico officials have interpreted the constitutional debt limit to not include certain types of debt, such as swaps, a complex financial transaction into which certain issuers enter that transfers the risk of interest-rate fluctuations between the issuer and its counterparty.
PBA Funds, a group which holds PBA bonds, objects to the attempts to annul its debt, contending the FOMB brought the litigation to mount pressure in anticipation of negotiations among various classes of creditors, with respect to a commonwealth adjustment plan. “They are not serious in seeking a judicial determination on the question of whether the PBA leases are true leases or a disguised financing,” PBA Funds said.
First, the group said, there is no allegation that any of the PBA leases contain the crucial term that is the hallmark of a financial transaction, which is the ability of the tenant to convert monthly payments into equity or an ownership interest in the leased premises, as would be the case in a mortgage. “The case law on this issue is clear that without such an ownership interest, the ‘lease-disguised-as-financing’ argument fails,” PBA Funds said.
Those leases, PBA Funds added, continue to enjoy the presumption that they are true leases.
PBA Funds also noted that the Oversight Board is attacking the portion of the rent payments designed to service debt, but not the portion designed to cover operating expenses, such as the salaries and benefits of PBA employees.
James Spiotto, in an article titled “Puerto Rico’s Repudiation of General-Obligation Bonds: A Real Risk or Just Kabuki Theater,” said repudiation of claims of the invalidity of previously issued GO bonds by states or even local governments historically have never been viewed by the market as an acceptable or respectable position for an issuer who had earlier represented, through its statements and its agents, that the bonds were valid and in compliance with the law. “Generally, constitutional debt limits or balanced budget requirements are guideposts for the governmental issuer, in conjunction with bond counsel prior to actual issuance, to determine whether such debt can and should be incurred. These provisions were not intended to create an artifice that clever government issuers could spring on unsuspecting good faith bond purchasers, who had no prior notice of any defect, and in fact were told at issuance there were no compliance problems with the Constitution and law of the government,” he said.
Spiotto said the U.S. Supreme Court and many federal courts consistently supported bondholder rights in cases, such as the one in Puerto Rico, especially if the debt was issued in good faith. However, it has been invalidated in different circumstances, such as the 1880 case Buchanan v. City of Litchfield, because there was a failure to have any recitals or representations about full compliance with constitutional provisions relating to debt limits and a failure to have any assessment valuation for the relevant year permitted in the question of invalidity.
“Puerto Rico, in connection with the issuance of the asserted invalid [GO] bonds not only stated specifically that the bonds were in full compliance with the Constitution and laws of Puerto Rico but also, in the Official Statement, detailed the calculation and determination by Puerto Rico that the GO debt limit was not violated. It is illogical and unrealistic to require or expect the bona fide bond purchaser to be better able to perform the calculation than the government issuer, [which] is the one tasked to make the determination before issuance of the bonds,” he wrote.
However, what do the bond documents say? The disclosure statement for the 2014 bond issue identified as a risk factor that the government might reach the debt cap in the future and the constitutional guarantee does not cover any debt incurred over the cap. It also states that there is some debt issued by certain instrumentalities that is guaranteed by the full faith and credit in what appears to be a reference to the PBA debt. While bondholders often do not pay attention to bond documents, the warning was there.
“According to opinions provided by the secretary of Justice of the Commonwealth, bonds and notes of certain instrumentalities that are guaranteed by the good faith, credit and taxing power of the Commonwealth (Guaranteed Obligations) are considered public debt and enjoy the same priority of payment protection that is afforded to bonds and notes issued by the Commonwealth for which its good faith, credit and taxing power has been pledged (Direct Obligations). As of Dec. 31, 2013, there were outstanding $5.6 billion in Guaranteed Obligations and $10.2 billion in Direct Obligations. After the issuance of the bonds and the refunding of the refunded bonds, the amount of Direct Obligations outstanding will increase to $13.3 billion. The Commonwealth may continue to pledge its good faith, credit and taxing power to guarantee additional bonds and notes issued by certain of its instrumentalities,” the bond document says.
A lawyer consulted by Caribbean Business, who declined to use his name because he is close to the case but not authorized to speak about it, said Puerto Rico should not be penalized for trying to enforce, after the fact, the debt limits or balanced budget clauses because it will force officials and executives working on these transactions in the future to be more careful in order to protect debtors from
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