Will the Fiscal Control Board Follow the Detroit Model?
As Puerto Rico starts anew on the path toward financial stability, many Puerto Ricans hope the Financial Oversight & Management Board will end years of wasteful spending by the commonwealth government and bring about economic prosperity, while others fear the island will be worse off in the end.
The board recently gave signs that it plans to promote austerity in government rather than engage in measures that would jumpstart the economy. During its recent meeting at El Conquistador Resort in Fajardo, board members told the Gov. Alejandro García Padilla administration to redo its proposed 10-year fiscal plan by removing additional federal funds from the plan that the island was hoping to receive, which are deemed uncertain, particularly in a Donald Trump presidential administration. This appears to be a sign that the board will cut public payroll and incentives, actions that, according to experts, could aggravate Puerto Rico’s dire economic situation. In response, García Padilla has said he will not redo the fiscal plan to add more austerity measures and is leaving the matters in the hands of the incoming Gov.-elect Ricardo Rosselló.
Besides a nearly $70 billion debt, Puerto Rico also has $44 billion in pension debt. Government officials have already warned of several liquidity cliffs that would take place next year. One is the loss of Obamacare healthcare plan funds, the other is the crisis in government pensions and yet another is the government’s insolvency. Around 21% of the government’s budget is dependent upon the tax collected through Act 154 from a small group of companies.
What the future holds for Puerto Rico remains uncertain, but experts agree that while the government needs to make budget cuts, it is also best if officials renegotiate debt payments with creditors rather than allow the board to restructure the debt through the provisions of the Puerto Rico Oversight, Management & Economic Stability Act (Promesa), because this would inevitably lead to job reductions as well as severe cuts to government pensions that would put the economy in a tailspin.
“The Puerto Rico Manufacturers Association [PRMA] does not support any policy that establishes debt restructuring as the primary issue. We support all initiatives aimed at government austerity and financial transparency, clarifying that we must defend all private and public jobs and we do not support any efforts to downsize government that may have a negative impact on our weak economy and very fragile labor market. Efforts must be made toward the consolidation of agencies, functions and services through budgetary austerity measures and other efforts toward governmental efficiency. However, retraining government employees should be a priority,” said PRMA President Rodrigo Masses.
Since New York City’s highly publicized oversight board was established in 1975, more than 119 municipalities of all sizes have been assigned control boards because of their dire finances, according to published reports. Some municipalities have managed to prosper, while others are still struggling. One recent example is the city of Detroit, whose appointment of a fiscal oversight board has left some disappointed that the process has not brought enough economic prosperity. Detroit filed the nation’s largest Chapter 9 bankruptcy in July 2013 with more than $18 billion in debt and city services in shambles. The city emerged from bankruptcy in December 2014 when the court accepted its reorganization plan. The latest report from Michigan shows that the city of Detroit has an unemployment rate of about 6%, which is higher than the national state average of 5% but much less than Puerto Rico’s estimated 12%.
For years, Detroit’s economy has been struggling because the city has lacked access to the capital markets and has not been able to invest in essential services, let alone the growth initiatives needed to restore the city’s economy, according to experts. However, it should be noted that Detroit returned to the capital markets in 2015, just two years after filing for bankruptcy.
Experts say that the cuts in Detroit’s bonds, which exceeded the reductions imposed on the city’s pension participants, whose claims are inferior to bondholders in bankruptcy law, had made it impossible for the city to return to the bond market without the explicit backing of the state government. Some assert that debt reductions reduced the pressures to do fundamental economic reforms.
A key difference between Detroit’s oversight board and others that have been successful is that Detroit’s was established as part of a broader Chapter 9 process and engaged in substantial debt restructuring.
Skeel puts bondholders at the top of the list
While Caribbean Business was unable to get an interview with oversight board members to get their views on the path Puerto Rico should follow, David Skeel, one of the board members, recently put in writing his views, which included that creditors should recover as much as reasonably possible, while government agencies should get cuts.
Skeel, who is a lawyer, said creditors must be protected from “unfair discrimination” and “best interests” in order to avoid another Detroit scenario. “The rule of law took a beating in the Detroit bankruptcy. Creditors who held that city’s GO [general obligation] bonds, which had the same priority as pensions, received only about 41% of what they were owed, and several classes of creditors that voted against the plan received far less. Pensioners, meanwhile, received 60% [to] 70%,” he wrote.
To protect the future investment potential of Puerto Rico, he indicated that Congress should explicitly require that recovery rates for creditors with the same priority cannot deviate more than a specified amount, such as 15% or 20%, as this would be a way to “discriminate fairly.” Additionally, he said a restructuring plan should guarantee as much recovery for creditors as is reasonably possible, as opposed to the “something’s better than nothing” ruling handed down in Detroit.
Skeel also said any restructuring should address the obvious governance dysfunction that is frequently a primary cause of fiscal distress. “Puerto Rico exemplifies this dysfunction, as about 120 government agencies provide services on the island with insufficient centralization to avoid overlap and to coordinate responsibilities. A plan that fails to eliminate or consolidate government agencies should be rejected as not feasible,” he stated.
Between Scylla and Charybdis
This situation puts Puerto Rico between a rock and a hard place because cutting pensions as part of a restructuring will severely hurt thousands of government retirees, many of whom already receive measly pensions of as little as $500 a month. On the other hand, government officials agree that any government restructuring to reduce debt should avoid massive layoffs.
A Caribbean Business analysis has found that reducing public payroll by 20% would result in Puerto Rico’s gross domestic product contracting by minus 0.7%, while a 40% payroll cut would result in a minus 1.4% contraction in the local economy.
Economist José Joaquín Villamil expressed concerns that “no one” is talking about measures to jumpstart the economy in the short term and in a sustainable manner. “The fiscal crisis will not be resolved unless the economy grows,” he said.
He added that the oversight board has been clear in letting the government of Puerto Rico know that it should not put its faith in Washington, D.C., because the federal government has not talked about giving Puerto Rico tax incentives similar to the defunct tax credits of Section 936, or more federal funding. “The board has not told García Padilla to do a fiscal plan with more austerity measures, but to simply comply with Promesa,” he said.
Two options under Promesa
Under Promesa, Puerto Rico has two ways of dealing with its debt. One is through Title III, a series of provisions under which Puerto Rico itself or an instrumentality selected by the oversight board can file a case in court to reorganize its debts under an adjustment plan that has numerous provisions borrowed from the Bankruptcy Code. Under Promesa, the criteria for Puerto Rico or an instrumentality to be eligible to file a debt-restructuring proceeding include approval by the oversight board and the desire of such entity to effect a plan of adjustment. The oversight board, in approving the filing, must certify that the entity has engaged in good-faith efforts to enter into voluntary agreements to restructure its debts, has an approved fiscal plan and has no “qualifying modification” of its bond debt, among other things.
The second route that Puerto Rico can follow under Promesa is under the collective-creditor action provisions of Title VI, which provides an overall bond restructuring of Puerto Rico or an instrumentality as a general alternative to the debt-adjustment provisions under Title III discussed above. Title VI provisions permit the terms of bond obligations to be modified based on the collective action of applicable bondholders, but without the 100% consent of all affected bondholders.
Villamil argued that the government should have accepted a restructuring offer made by GO bondholders and some Sales Tax Financing Corp. (Cofina by its Spanish acronym) bondholders to pay interest on the debt and postpone payments on debt principal for five years. He claims the government failed to accept that because it was under pressure from law firms such as Millstein & Co. to restructure and because former Government Development Bank President Melba Acosta said it did not resolve the problem. “I think there is still time…. It will be up to the next government to [renegotiate][,” he said.
Villamil noted that Detroit’s path to debt restructuring under Chapter 9 of the Bankruptcy Code has been successful in some aspects, but it has been at a high social cost. “Detroit was a chapter 9 case; what we have in Puerto Rico is something else,” he added.
However, he said Puerto Rico’s government should try to renegotiate its debt because if it is unable to do so, it will be up to the oversight board to restructure and the board will use austerity measures and cuts as the primary basis.
Mixed reviews for Detroit
Nuria Ortiz Vargas, executive director of Espacios Abiertos, recently traveled to Detroit with other organizations to interview journalists, lawyers and officials to ascertain the impact of the city’s restructuring process. She concluded that the restructuring improved the city’s numbers, but “communities are not in better shape.”
She said parts of the city, such as the downtown area, have been renewed and look vibrant, but other parts of the city remain in shambles. However, it should be noted that Detroit went into a downward spiral for years, so it is premature to expect that three years into the process, the Motor City should be magically transformed.
Officials told Espacios Abiertos that during the summer of 2014, water tariffs were increased to the point where many people could not afford to pay them and 30,000 people had their water cut off with all the social consequences of the decision. There was also the problem of mass tax foreclosures that drew long-time residents out of the city, a phenomenon that Detroit has been suffering for years.
Espacios Abiertos pointed to the importance of raising awareness about the real needs of the residents of Puerto Rico to “face the myopic insistence that our problem is one of pure mathematics without taking into account the structural limitations that block socioeconomic development and sound government.”
While the city of Detroit managed to restructure its accumulated debt and developed a plan to deal with its retirement crisis, many structural reforms have still not been done because the restructuring merely focused on the financial aspects.
There are as many differences as there are similarities between Detroit and Puerto Rico, and the group said there are lessons to be learned. Espacios Abiertos said the crisis cannot be resolved if the priority is on the numbers and financial aspects, while ignoring the human cost of each decision made. Ortiz Vargas also stressed the importance of defining essential services and ensuring they are not subject to political interests or the interests and ideologies of the members of the board, and on the need to be alert about the decisions that are made regarding the government’s assets.
She noted that Detroit’s bondholders proposed selling assets such as paintings and other valuables to pay pensions. The sales were avoided after organizations provided funding to deal with the city’s pensions. She said Puerto Ricans must pay attention to the possible privatization of services to avoid a tragedy such as what happened in Flint, Mich., where some residents were poisoned after switching water resources.
What about Washington, D.C., which had a successful debt restructuring and was under a financial oversight board?
The city faced a budget shortfall of $700 million and could not file for bankruptcy protection that was available to other U.S. cities. In an attempt to fix D.C.’s finances, Congress established a five-member oversight board in 1995 that was charged with balancing the budget in four years.
Besides eliminating billions of dollars in spending, the D.C. board also examined all regulatory actions by the city and set aside those that did not pass a basic cost-benefit test.
In the aftermath of the oversight board, the city’s economy has improved. Villamil, however, said Washington, D.C., was able to recover in great part because of the federal government expansions following the Sept. 11, 2001 terrorist attacks, whereas Puerto Rico’s economic recovery remains a huge question mark. Puerto Rico, unlike Washington D.C., has already defaulted on its debt payments.
“Washington D.C. did not have an economic collapse, but more like bad management,” Villamil said.
Former P.R. Secretary of State Kenneth McClintock believes Puerto Rico could do cuts without doing layoffs by reviewing all government contracts and getting rid of those that have nothing to do with essential services. “From what I have read in the press, there is an excessive amount of unneeded contracts,” he said, pointing out that each agency must be examined thoroughly to determine what expenditures are essential and which are not.
He also stressed the need to “sit down with creditors” and renegotiate in good faith. He said many of Puerto Rico’s creditors are not billionaires, but regular people who invested their savings in commonwealth bonds.
McClintock also believes that Puerto Rico has numerous job producing sectors, such as in the areas of tourism and infrastructure projects. In that regard, he stressed the need to “deregulate the economy” to facilitate business and job creation.