EMTA Special Seminar: Puerto Rico Debt Crisis and Its Significance for Other Municipal Markets (NYC) - Feb. 18

 

Puerto Rico and the Muni Market

This Special Seminar “Puerto Rico Debt Crisis and its Significance for other Municipal Markets” took place at EMTA’s offices in NYC on February 18, 2016. Arturo Porzecanski (American University) moderated the panel, with the following panelists:
Hector Negroni (Fundamental Advisors LP), Matthew McGill (Gibson, Dunn and Crutcher LLP), Mark Muller (Loews Corporation), Andrew Rosenberg (Paul, Weiss, Rifkind, Wharton & Garrison LLP) and George Carroll (GO Bondholder and Former Municipal Bond Market Professional). Relevant documents addressed during the panel discussion can be accessed by Clicking Here.

How Puerto Rico manages its debt crisis will be a case study for other cities and states that face spending, budget and debt problems. It is yet to be seen how the government will handle upcoming debt payments, but the implications of its decision goes well beyond the local economy. A federal or territorial means of abrogating General Obligation bonds at the municipal level will increase risk premium, raise borrowing costs and potentially destabilize other municipal markets. This panel explored the existing challenges for the government of Puerto Rico, the role of the federal government in its crisis, and the substantial threat of its decisions to the national municipal bond market, to the ability of states to borrow, and to retirement accounts for millions of pensioners.

Porzecanski set the context for the panel discussion by explaining that the restructuring of Puerto Rico’s obligations has been a process as “wild, confusing, engrossing and dramatic as was the original-format Ringling Brothers and Barnum & Bailey three-ring circus”. “Playing in Ring #1” are attempts by Puerto Rico to obtain debt relief, while respecting existing laws and indentures, mainly via voluntary exchanges of old bonds for new ones embodying significant principal and interest-rate concessions. It stars the long-running negotiations between the Puerto Rico Electric Power Authority and its creditors over some $9 billion in Prepa debt. Lately, however, these exchanges and negotiations have been overshadowed by the presentation of an exchange offer to holders of Puerto Rico’s $49 billion of tax-supported debt, which proposed an up-front write-off of 46% of the principal owed plus grace periods and interest-rate concessions, which all together implied NPV losses ranging up to 70%, akin to those seen in bankrupt countries (e.g., Argentina and Greece).

Playing in Ring #2 are attempts by Puerto Rico to obtain debt relief under newly legislated bankruptcy regimes, which would override existing laws and indentures. These regimes are of three types: the one legislated by Puerto Rico in mid-2014, the so-called Recovery Act which sought to establish a debt enforcement, recovery and restructuring regime for the public corporations and other instrumentalities of the Commonwealth. It has been challenged and twice found to be unconstitutional in the federal courts, and is now up for review by the Supreme Court (with a hearing scheduled for March 22). The second regime type is the one originally proposed by Democrats in the U.S. Congress, filed as HR 870, to apply to entities like Prepa and municipalities in Puerto Rico, but not to General Obligation and tax-supported debt; it is known as the Chapter 9 debt-resolution framework, which Washington would authorize by defining Puerto Rico as a “State” for purposes of Chapter 9 of the U.S. Bankruptcy Code. And the third regime type, known as a Super-Chapter 9 resolution framework, backed by the Obama Administration, would have Washington authorize the most comprehensive restructuring of Puerto Rico’s debt obligations either as an amendment to the U.S. Bankruptcy Code or as a law under the Territories Clause of the Constitution (Article IV, Section 3, 2nd Clause).

Playing in Ring #3 are attempts mostly by Republicans in Congress to impose a federal financial control board on Puerto Rico which may or may not have the power to restructure the Commonwealth’s debt obligations. Given the seemingly irreversible loss of investor and rating-agency confidence in Puerto Rico’s ability and willingness to pay, and especially given the Island’s timid and inept political leadership, increasingly paralyzed by a looming election cycle, the time may well have come for the kind of intervention that will ensure the unpopular revenue-raising and expenditure-cutting decisions that dire circumstances warrant. The proverbial devil is in the details, however, because prior control boards, whether established by Congress for the District of Columbia in the mid-1990s, or by states for the likes of Cleveland, New York City and Philadelphia, had different mandates and powers.

Responding to Porzecanski’s questions with regard to the panelists’ reflections on the negotiations between Prepa and its creditors, whether such negotiations provide an object lesson on what’s right or wrong with a case-by-case, negotiated approach to over-indebtedness and whether the political interference plaguing the restructuring has convinced them that the appointment of a receiver or a federal manager would have been better for all the parties, Negroni stated that Puerto Rico was greatly mismanaged, with a “grossly obese government” and with tax revenues “to be ashamed of”, leading to an underground economy. Instead of making the difficult decisions of governing, it made special rules for itself, leading to a narrative that was not realistic and a crisis appeal to the US federal government, thus making Puerto Rico a chess piece in the US political process. With 78 municipalities with its redundancies and inefficiencies, what was a liquidity crisis has now become an insolvency problem.

McGill was in favor of a case-by-case approach, although it did depend on whether restructurings were possible. However, neither Congress nor Puerto Rico should be permitted to change the terms of a contract. He cited the Constitutional contract clause, whereby the federal government under the Territories Clause could do certain things, but was restricted by the takings clause (and even the Bankruptcy Code was so restricted). Muller, as a COFINA creditor, views the PREPA negotiations as an example of a possible path forward to a restructuring agreement. He has been impressed thus far with the working relationship between the debtor and creditors, pointing out the liquidity granted by creditors while in a state of forbearance. Rosenberg, who represents institutional debt holders, viewed the process as taking too long, with proposals that were short-sighted by limiting future access to the capital markets.

Responding to Porzecanki’s query on panelists’ judgment of the Commonwealth’s restructuring plan based on the unique assessment of market value and not debt levels, whether the losses envisioned for the various categories of debt made sense, whether the extent of debt forgiveness sought was justified by the degree of fiscal austerity that the authorities have offered in return and whether there were any relevant precedents, Rosenberg was reticent to comment, noting that negotiating in public was not the best course of action that would lead to things getting done, but he thought there were sufficient revenues available to sustain the debt levels. Negroni, while thrilled that a proposal was suggested, found it to be a “histrionic” gesture 6 to 9 months too late (which was mainly a problem for the population), with a parallel lobbying effort for a magic wand from DC, all in all an “extraordinary unprecedented authority with effects on the economy and people”. Carroll laughed at the proposal, “like most people” as a non-starter, and noted that the American taxpayer will be affected by Puerto Rico’s losses as write-offs on overall taxable income will also detrimentally affect US tax revenues. Muller viewed the proposal as “dead on arrival”, with haircuts limiting debt capital, leading to extreme imbalances instead of needed structural reforms.

Porzecanski, turning to Ring #2, then asked about the issues, scenarios and timing for a Supreme Court decision on the Recovery Act, how much of a difference will Justice Scalia’s absence make, what are the panelists’ views on the wisdom of a Chapter 9 versus a Super-Chapter 9 framework for Puerto Rico, what are the pros and cons of shoehorning in the Island via an amendment to the U.S. Code versus special purpose legislation under the Territories Clause and what kind of precedent would be set under the various scenarios.

McGill, representing the Blue Mountain Prepa creditors, stated that legal uncertainty is created by the Recovery Act (a “debt avoidance law”), which then allows for restructuring to begin. A Supreme Court decision is expected at the end of June. With Justice Alito recused, the passing of Justice Scalia does not have as much of an effect since there will now need to be a majority of 7 (the first liberal majority to decide a case in years). Scalia’s view was that rules should be clear and understandable, and he did not judge on the basis of what would be the best outcome, most just or most in accord with public policy. Since Puerto Rico is a state for purposes of the Bankruptcy Act, and since the text of that statute states that there should not be a state law that addresses the topic of municipal bankruptcy, the Recovery Act on its face is unconstitutional since it purports to do so. The question turns on whether Puerto Rico is a state or territory (and, in a criminal case also before the Supreme Court, it seems the Commonwealth is attempting to have it both ways, depending on the case at hand). He proceeded to provide a history of Congressional approval in 1984 for Puerto Rico to become a state (like DC) for all purposes except Chapter 9, but retained for Congress the power to determine how to deal with debt problems of those two regions (enacting a successful control board for DC).

Negroni’s view is that Puerto Rico is subject to the Bankruptcy Code, including Chapter 9, as he is a fan of market structure and a champion of harmonization. The municipal market is held together by the full faith and credit principle, the rule of law and the notion of 50 state sovereigns. Investors think of Puerto Rico as a state and it would be a disruptive and destabilizing precedent if it were otherwise (not to mention if other states availed themselves of a similar Recovery Act loophole). While Chapter 9 may “have its warts, it’s the best we have”. While Puerto Rico needs a framework for insolvent credits, the unique Recovery Act framework for political expediency reasons is not advisable. Muller is against Chapter 9 and Super-Chapter 9 and supports the Recovery Act. He pointed to the Chicago Public School bond issuance as an example of how the invocation of Chapter 9 in that case was detrimental. Rosenberg, echoing consistency and fairness, believes that Puerto Rico should have Chapter 9 rights and protections as other states do, but it should not have Super-Chapter 9 protections that would permit a state to file for bankruptcy (vs. its municipalities). Since other states are able to work through the system with “regular” Chapter 9, Puerto Rico should as well. The Bankruptcy Code already has provisions for amendments, as needed. There would be a huge contagion legal risk if states (especially those high debt states, such as California, Illinois and New Jersey) were allowed to file for bankruptcy through an amendment to the Bankruptcy Code. In addition, talking about insolvency often leads to the self-fulfilling prophecy of real insolvency with high attendant borrowing costs. And, “untested, special one-off legislation” is a “slippery slope, risky, perilous and dangerous”. The Constitutional issues are troubling (the takings clause), as are the uniformity claims issues. Chapter 9 is the last resort after the parties have tried negotiation.

With regard to Ring #3, Porzecanski asked panelists if they were in favor of the imposition of a federal financial control board, if they viewed it as the natural quid-pro-quo of giving Puerto Rico legal access to some kind of restructuring mechanism, what were the pros and cons of bestowing on such a board the power to rip up existing bond indentures and what kind of precedent would be set by either scenario.

Carroll is in favor of the control board providing some direction (and maybe Chapter 9 is then not needed), while some products can be negotiated individually without government intervention. In DC, the control board was disbanded after four years after balancing the budget. Rosenberg has no appetite for a US government bail-out in this form, and finds this (like the Super-Chapter 9) an “increasingly bizarre-sounding legislation” to deal with debt problems and a possible “back door” to Super-Chapter 9 implementation, with attendant contagion risks. Muller is not as opposed, citing other state and municipal examples (New York City, Cleveland, Pittsburgh, Orange County, California, now Atlantic City) that were successful, and claiming that DC and Puerto Rico need a federal source like a control board since there is no other state authority.

Finally, Porzecanski asked if the panelists had any ideas for how to come up with a new business model for Puerto Rico as a whole, or at least for the Island’s public sector, and what should and should not be done in the months ahead to maximize the chances that the Commonwealth will be able to come back to the municipal bond market by 2020.

Negroni thought that it cannot reform with the current government without ceding authority as a fiscal matter to some control board. With declining credibility in the government, one needs fiscal oversight, reduction of expenses, better disclosure and addressing of poor tax collections, all in conjunction with restructuring reform (not invented in Congress). “Puerto Rico has to be a place where people have faith in it”. Puerto Rico had to “own its debts”…and not rely on “friends with benefits”. McGill claimed there won’t be growth in the private sector until Puerto Rico embraces the rule of law. Rosenberg reiterated the goal of access to the capital markets, with the antithesis of refuting existing debt.