Puerto Rico may be liable for incomplete Cofina, GO bond disclosures
The Independent Investigator’s report on the causes of Puerto Rico’s debt devoted numerous pages to the potential liability against the government, most notably its failure to disclose problems with the structure of the Puerto Rico Sales Tax Financing Corp. (Cofina by its Spanish acronym) and the 2014 general-obligation (GO) bonds.
The independent investigator’s report said the government should have also disclosed legal opinions that put in question the legality of Cofina’s structure. It also should have disclosed that it had hired professionals with reputable restructuring experience a month before the 2014 GO bond issue, which was the last time the government went to the markets.
On March 11, 2014, just over one month after Puerto Rico’s bonds were downgraded to junk status, Puerto Rico issued $3.5 billion in GO bonds. The risk factors section of the 2014 GO Bond Official Statement begins by warning that the “Commonwealth and its instrumentalities face a number of fiscal and economic challenges that, either individually or in the aggregate, could adversely affect the Commonwealth’s ability to pay debt service on the bonds when due.”
Several witnesses involved with the 2014 GO bond issuance told investigators that the risk-factor section of the 2014 GO Bond Official Statement was extensive and thorough, and included the possibility of a debt restructuring.
In addition, according to the witnesses, the bond denomination was $100,000, which served to protect unsophisticated investors from buying the bonds, the report said.
Despite the apparent lack of plans to restructure and the absence of a legal mechanism for Puerto Rico to restructure at that time, the Government Development Bank (GDB), the island’s fiscal agent, hired Millco, Cleary and Proskauer Rose prior to the 2014 GO bond issuance. Millco was a reputable restructuring firm and both Cleary and Proskauer were law firms with reputable restructuring practices.
Despite Millco’s statement that it was not hired to provide advice for restructuring of Puerto Rico obligations, the report said one witness noted that several underwriters requested disclosure of the Millco hiring in the GDB’s liquidity projections, which were ultimately referenced in the Official Statement of the 2014 bond issue. However, the independent investigator noted the island should have disclosed in the bond issue report the hiring of law firms with restructuring experience. “We found that even though Puerto Rico had disclosed with the 2014 GO Bond Issuance potential emergency measures, including a restructuring, Puerto Rico did not disclose that it had retained law firms with reputable restructuring capabilities on Feb. 3, 2014, [which was] just over one month before the bonds were issued,” said the report, which was written by Kobre & Kim.
Witnesses who worked on the bond issuance stated that Cleary was not hired in January 2014 to conduct a debt restructuring, but to advise on alternatives for various contingency scenarios with respect to Puerto Rico and its agencies. A witness also stated that issuers typically do not disclose the names of the law firms they hire.
However, on June 28, 2014, the Recovery Act was enacted, which established a restructuring regime for certain issuers, including public corporations. “Witnesses told us that Cleary and Proskauer helped draft this legislation. One investment banker and an underwriter reported that Puerto Rico did not tell underwriters that it had retained Cleary in the time between the engagement and the time it was made public. Another banker reported he was very surprised to learn in April that Cleary had been hired, and was shocked to learn in May 2014 about the consideration of the Recovery Act. The witness stated the underwriters were completely surprised to learn about the restructurings, as were the rating agencies and the market. The witness reported he told GDB personnel that he thought the restructurings were a violation of representations Puerto Rico had made to investors about its commitment to honor its [GO] debt,” the report said.
On the other hand, the Cofina bond issues created significant controversy after Puerto Rico became unable to pay its debts. Certain creditors, including holders of Puerto Rico’s GO bonds, challenged the transfer of sales & use tax revenues to Cofina because they say the funds should have been used to satisfy amounts owed on their GO bonds. Among other things, the creditors asserted Cofina was created to circumvent Article VI of Puerto Rico’s Constitution, which they claim gives them a Clawback Right.
In June, Cofina and holders of GOs reached an agreement to settle their dispute.
Cofina was created in 2007 with the idea of using a dedicated revenue stream from a new sales & use tax to back bonds that would, because of the source of that revenue, be a safe investment. Cofina ultimately issued bonds in 2007, 2008, 2009, 2010 and 2011.
Before the first issuance of Cofina Bonds, there were questions about the legality of its structure. At the GDB, there were internal discussions about the “clawback risk,” or the risk under the Puerto Rico Constitution that the sales & use tax revenue could be subject to the Clawback Right of GO bondholders because the proceeds from this revenue stream could not be diverted from the general fund. On the subject, Cofina’s underwriters ultimately said that if a dispute were to come before the Puerto Rico Supreme Court, the sales tax securitization structure would be found to be constitutional and does not violate the GO bondholders’ priority rights under the Puerto Rico Constitution.
“Publicly available evidence reflects that sometime prior to mid-March 2006, at least one attorney had advised the GDB that, under the Puerto Rico Constitution, the sales & use tax could not be diverted away from the general fund,” the report said.
Sidley Counsel, who had long served as bond counsel for Puerto Rico-related bond offerings, said in a May 2007 email to Jorge Irizarry, who was the GDB head at the time, that a court would have a hard time concluding the sales-tax revenues are not “available” to the Commonwealth should it need the money to pay GO debt.
Sidley Counsel, as a matter of fact, declined to provide a legal opinion concluding that if the issue were to come before the Puerto Rico Supreme Court, the sales tax securitization structure would be held constitutional and not be found to violate the GO bondholders’ priority rights under the Puerto Rico Constitution. In a subsequent email, Counsel recommended adding language to the investor disclosure on bond issues reflecting the lack of judicial approval of the proposed securitization structure. However, Cofina opted to retain the Hawkins law firm as bond counsel to provide an opinion that the sales & use tax pledged to Cofina did not constitute the “available resources” of Puerto Rico.
While Act 91, which created Cofina, has not been challenged in any court of law, none of the Official Statements for the 2007 through 2008 bond issuances includes the additional language that Counsel had recommended concerning the uncertainty in that area. The language was included in the Series 2009 Cofina bonds as a risk factor.
“The earlier Cofina issuances in 2007, 2008 and 2009 raised questions about potential material misrepresentations and omissions relating to the failure to disclose discussions about the constitutionality of the Cofina structure and Puerto Rico’s existing long-term bond counsel’s refusal to issue an opinion concerning Cofina,” the report said.
In 2010, Nixon Peabody replaced Hawkins as bond counsel for Cofina for bond issuances between 2010 and 2011. During an investor call—a public conference call hosted by the GDB to discuss the opinions shortly after their issuance—lawyers with Nixon Peabody and PMA (Puerto Rico-based underwriters’ counsel) suggested that Cofina could not seek judicial review of the constitutionality of its structure because no case or controversy existed for the court to review.
“These statements may not have provided all potentially relevant information, because a declaratory judgment action or petition for writ of mandamus to determine the constitutionality of Cofina may have been viable. In fact, Puerto Rico has had a declaratory judgment mechanism since 1979,” the report said.