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Puerto Rico's Challenge

Puerto Rico’s debt has long been attractive to municipal investors. The Commonwealth’s bonds carry high yields and are exempt from local, state, and federal income taxes.

However, the Commonwealth today is flirting with insolvency, and the risk is growing that someday, Commonwealth investors may not be repaid, in full. Puerto Rico’s financial condition is far worse than any U.S. state’s, and a default – though unlikely in the immediate future – is a possibility over the next few years.

Breckinridge has long avoided obligations of Puerto Rico, but we believe all municipal bond investors should now be cognizant of its problems. A Commonwealth default would have significant ramifications for the municipal market.

In this Special Commentary, we introduce the Commonwealth and its financial situation, and we speculate on the market impact of a Puerto Rico bond default. Our discussion begins with a brief introduction to the Commonwealth’s governance, the “status issue,” and its economy. It next moves to an overview of the island’s poor financial condition. We then discuss how recent reform initiatives – coupled with the lack of a “trigger event” – make a default unlikely, at least in the near term. We conclude with a discussion of such a default’s impact on the market and the legal precedents that might emerge from it.
 

An Introduction to the Commonwealth: Government, Politics, and Economy

Government

The Commonwealth closely resembles a U.S. state. It has a bicameral legislature, and its governor is elected to a four-year term. The island’s judicial system is indistinguishable from a state court system.1

However, Puerto Rico is unique in its extensive use of public corporations to deliver public services. It directly and indirectly manages 48 public benefit corporations.2 This governance structure has tended to limit transparency and fiscal accountability in its public sector.

The island’s most important public corporation is the Government Development Bank (GDB). The GDB is the fiscal agent, paying agent, financial advisor, and primary lender to the Commonwealth, its political subdivisions, and its public corporations. Puerto Rico’s growth and financial stability require a healthy GDB.
 

The “Status Issue”

A perennial issue for Puerto Rico and its politicians is whether to support applying for U.S. statehood. The island’s major political parties are divided on this policy matter, known as the “status issue.” A Commonwealth default would likely compel a national discussion of the “status issue.” It is uncertain how this discussion would unfold and what it might mean for Puerto Rico’s bonds.3 However, the Commonwealth’s current Governor supports statehood.4
 

Economy

The Puerto Rican economy entered recession in late 2006, and it has yet to emerge. Rising oil prices, government downsizing, and the end of tax advantages for manufacturers were the immediate causes of recession.5 The Great Recession compounded the island’s problems.
 
Puerto Rico's Real GDP Growth has been Negative or Modest for Several Years

The island’s recent economic quagmire also results, in part, from decades of industrial policy. Since the 1950s, the Commonwealth has invested heavily in infrastructure, education, and the development of high-tech manufacturing to spur growth. Concurrently, the federal government has subsidized Puerto Rico’s debt through “triple-tax-free” bonds,6 Puerto Rican manufacturers through corporate tax breaks,7 and Puerto Rican residents through direct transfer payments.8

These investments and subsidies have raised basic living standards.9 However, median household incomes in Puerto Rico remain at $15,000, and only 35% of Puerto Ricans are employed.10 Also, dependence on federal tax incentives and transfer payments has limited the island’s long-term growth prospects.11
 

Puerto Rico’s Financial Condition is Weak

Poor financial management has contributed to the length and depth of Puerto Rico’s recession. The Commonwealth is burdened by large annual deficits, a high debt burden, opaque financial practices, and severely underfunded pension plans, among other problems. The credit characteristics we highlight below are not new, but they have worsened dramatically over the last decade:

Annual Deficits: The Commonwealth has not balanced its budget in twelve years. The FY 2012 deficit (this year) remains large, at roughly $1.4 billion or 17% of general fund expenditures.12 This calculation excludes the accrual of annual pension expense.
 
The Commonwealth has Experienced Twelve Consecutive Deficits

Deficit Financing: The Commonwealth has issued debt to finance its annual deficits. Unlike healthy municipal issuers, the Commonwealth requires market access to meet payroll and other obligations.

A Rising Debt Burden: Annual deficit financing has caused the island’s debt-to-GDP ratio to rise. It is now 90%, compared to 57% in 2001.13 In fiscal years 2011 and 2012, the Commonwealth’s debt load grew while the economy contracted.14
 
Puerto Rico's Debt Burden is High and Growing

Inflexible Debt Structure: Puerto Rico’s debt structure is less flexible than other municipal issuers’. The Commonwealth repays only 21% of its debt within 10 years.15 This means there is little potential to free up cash by extending maturities through refinancing.

Politically Weak Bondholders: Relatively few Puerto Ricans own the island’s bonds.16 Municipal debt is typically owned by resident taxpayers who pressure their politicians to avoid bond defaults, but Puerto Rico’s creditors have a more limited voice in its politics.

Poor Forecasting: Puerto Rico consistently adopts aggressive economic and financial forecasts. The Government Development Bank has missed economic growth forecasts for three consecutive years.17 Politicians continue to tout progress on relatively weak financial and economic data.18
 
Puerto Rico's Growth Forecasts are Routinely Aggressive

Opaque Intra-governmental Borrowing: The Commonwealth’s major public corporations have significant and opaque financial relationships to each other and to the Commonwealth.19 These intra-governmental capital flows represent a significant portion of the island’s financial activities,20 and they are beginning to impact the island’s larger issuers. Last year, almost 28% of PREPA’s (Puerto Rico Electric Power Authority’s) unpaid bills were owed by delinquent public sector organizations.21

A Strained Government Development Bank (GDB): The Commonwealth’s vital Government Development Bank (GDB) is under stress. Roughly 35% of the GDB’s assets comprise loans to the Commonwealth and its public entities, and most of these loans are paid late.22 While the bank’s liquidity is ostensibly strong, it is weakly monitored. The GDB is unregulated by the Federal Reserve or Federal Deposit Insurance Corporation.23

An Increasingly Politicized Government Development Bank: The GDB’s loan book has become a bit politicized. In recent years, the GDB has entered into “fiscal oversight agreements” with several of the island’s large public corporations.24 These agreements require the public corporations to implement expense reductions, rate hikes, or submit to increased oversight to ensure the GDB is repaid. The bank’s intervention into areas traditionally reserved for policymakers increases its repayment risk.

Underfunded Pension Plans: Puerto Rico’s public pension funds were 14% funded in FY 2010,25 and a staggering 22% of the funds’ assets include loans to members of the fund. The Employees’ Retirement System may deplete its net assets by FY 2014 despite recent reforms.26 The Commonwealth’s pension funding shortfall is far worse than any U.S. state.
 
Puerto Rico's Pension Shortfall Far Exceeds That of Other States
 

Recent Reforms and Lack of a “Trigger Event” Suggest a Near-Term Default is Unlikely

Despite its poor economic and financial profile, the risk of a near-term default by Puerto Rico appears slim. Recent reforms appear sufficient to delay (if not forestall) a default. Equally important, the “trigger events” most likely to induce a Puerto Rico default seem unlikely.
 

Reforms

The Commonwealth has implemented a series of financial reforms during the past two years that have positively impacted its credit quality and growth prospects. These reforms (outlined below) include: overhauling the tax system,27 streamlining the island’s licensing and permitting process,28 reducing government expenditures,29 establishing a framework for public-private partnerships (essentially privatization of state assets),30 and several changes to the pension system.31
 
Puerto Rico has Enacted Several Important Fiscal Reforms over the Past Two Years

Puerto Rico’s economy is now nearing expansion.32 Tax collections have also improved, and the newfound ability to lease assets has buoyed the Commonwealth’s cash flow.33 Additional leases are planned, which should further improve short-term liquidity and limit default risk.
 

Trigger Events

Importantly, the events most likely to set in motion a default seem unlikely in the near term. These mostly include risks associated with Puerto Rico’s dependence on the capital markets and federal government.

Because it borrows frequently to fund operations, the Commonwealth must retain market access to avoid a bond default. A ratings downgrade, the elimination of the tax-exemption for municipal bond interest, or an increase in mutual fund redemptions would threaten this access. However, all three of these events seem unlikely:
 
  • Ratings Downgrade: Puerto Rico’s ratings of Baa1/BBB are barely investment grade. A downgrade could force some selling and significantly limit demand. Fortunately, this scenario is unlikely in the near-term insofar as rating agencies generally give struggling issuers time to implement planned reforms.
     
  • Elimination of tax-exemption: Federal tax exemption has supported retail demand for Puerto Rico’s bonds, which are exempt at the local, state, and federal level. Without this “triple tax-exemption,” Puerto Rico’s cost of borrowing would rise, as would the risk of a failed bond sale. Fortunately, federal lawmakers seem aware of Puerto Rico’s dependence on triple-tax-free bonds,34 and are unlikely to invite a default by pulling the subsidies for its debt.
     
  • Mutual Fund Redemptions: Many state-specific mutual funds are large buyers of Puerto Rico bonds, and they have supported the market for Puerto Rico’s debt quite well. Strong mutual fund inflows in recent years have given these funds the capacity to do so. However, when interest rates begin to rise, these funds may enter a prolonged period of redemptions and their capacity to keep buying Puerto Rico bonds may diminish. If those redemptions coincide with further deterioration in Puerto Rico’s credit quality, mutual funds could become sellers rather than buyers.
     
A debt crisis in Puerto Rico might also ensue as a result of federal government austerity measures. Cuts to Puerto Rico’s transfer payments and the end of favorable corporate tax treatment could significantly impact the island’s credit profile. However, we believe the negative effects of these austerity policies are unlikely to materialize in the near future.
 
  • Federal government cuts to Puerto Rico’s transfer payments. Puerto Rico’s citizenry depends heavily on federal government transfer payments, including those for food stamps, Medicaid, and social security. However, the federal government is unlikely to cut these programs independent of a wholesale reform, and there are only modest savings to be generated by reducing payments to Puerto Rico’s residents.
     
  • Job losses associated with the end of the preferential corporate tax treatment. Congress ended the “Section 936” preferential tax treatment for Puerto Rican manufacturers in 2006. Many of the companies affected by the change moved jobs off the island or restructured their corporate charter. It is likely a majority of job losses resulting from the 2006 tax change have already materialized.
     

Market Impact of a Default & New Legal Precedents

If the Commonwealth’s financial reforms prove insufficient to correct its financial imbalances or the above-mentioned trigger events become more plausible, a Puerto Rico bond default will become more likely. This would have a significant impact on the municipal market and might result in legal precedents of interest to municipal investors.
 

Immediate Market Impact of Default

The municipal market would likely react strongly and negatively to such a default. The market remains largely dependent on retail demand, and Puerto Rico’s debt is held widely by municipal bond mutual funds. Also, bond insurers are heavily exposed to the island.

The retail investors who comprise the bulk of demand for municipal bonds would likely be frightened by a Puerto Rico default. Such a default would invite disturbing but inaccurate headlines that Puerto Rico’s predicament presages U.S. state defaults. Investor skittishness could cause the market to underperform. Credit spreads would likely widen and liquidity might suffer.

A default would also directly pressure municipal bond mutual funds. Puerto Rico’s $60 billion in debt is held widely across these funds,35 and a default would decrease their net asset values and share prices, inducing additional market outflows.

A Puerto Rico default might also place further strain municipal bond insurers. Nearly 28% of the Commonwealth’s public debt is insured.36 To our knowledge, every major insurer has significant exposure to Puerto Rico.37
 

New Legal Precedents

A Puerto Rico default might result in new legal precedents. These include (a) how to restructure a federal territory, (b) whether bondholders can really enforce contract rights against states, (c) whether certain tax secured bonds dilute security for general obligation bondholders, and (d) the extent to which “sovereign immunity” is a viable defense for a state’s non-payment of debt.

Because it is a federal territory, there is significant uncertainty surrounding how Puerto Rico might restructure its debt. The Commonwealth is not a municipality, so it cannot adjust its debts through Chapter 9 of the bankruptcy code.38 It is also not a sovereign state, so it may have limited flexibility to renegotiate debt contracts. Instead, it is possible that Congress would compel Puerto Rico to adopt restructuring terms to its liking via the Constitution’s Territorial Clause.39 Some sort of “Congressional receivership” might prove the best option,40 but it is unclear how this would work.

A Puerto Rico default might shed light on the extent to which bondholders can enforce their contract rights against a state. Puerto Rico’s bondholders have a first lien on Commonwealth resources. However, math and politics make it unlikely that bondholders will be paid, in full, if the Commonwealth cannot both meet debt service payments and secure the public health, safety, and welfare.41 A ruling validating Puerto Rico’s ability to disregard its first lien pledge could conceivably weaken bondholder protections outlined in other states’ constitutions. Conversely, a ruling upholding Puerto Rico’s first lien pledge might strengthen bondholder security.

A default might also clarify when, if ever, tax secured bonds dilute security for general obligation bondholders. The Commonwealth’s COFINA bonds are backed by a new sales tax levy that arguably diverts revenue away from general obligation bondholders.42 It is unclear if Puerto Rico can segregate these sales taxes to the detriment of general obligation bondholders’ security.43 A ruling that upholds Puerto Rico’s right to segregate these taxes might induce more tax secured financing by U.S. states and reduce security for some general obligation bonds.

Another question is whether Puerto Rico can defend itself against a suit for nonpayment of debt by employing a sovereign immunity defense. The State of New Jersey successfully defeated a union-led lawsuit on sovereign immunity grounds earlier this year.44 Puerto Rico has sovereign immunity rights,45 and it is possible (albeit unlikely) that the Commonwealth has retained these rights with respect to bonds.46
 

Conclusion

Although the threat is not imminent and the risk remains slim, Breckinridge believes the possibility of a default by Puerto Rico is sufficient to warrant the attention of municipal investors.

A Puerto Rico default would have negative market implications. High grade investors should understand the Commonwealth’s fiscal problems because a default might trigger mutual fund redemptions and bouts of illiquidity.

However, Puerto Rico’s debt situation is unique and unparalleled in the United States. A debt crisis in Puerto Rico will have limited impact – if any – on the extremely remote likelihood of a U.S. state default.

We end with a graph that illustrates just how different Puerto Rico is compared a distressed U.S. state: Illinois. Illinois compares very favorably even though it faces several years of large structural deficits and large pension and retiree healthcare liabilities.
 
Puerto Rico's Economic and Fiscal Condition Compares Poorly - Even to Illinois

DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions.
 
1 See Sam Garett, “Political Status of Puerto Rico: Options for Congress,” Congressional Research Service, June 7, 2011.
2 For a listing of Puerto Rico’s component units, see the Commonwealth’s FY 2010 Comprehensive Annual Financial Report, pp. 66-74.
3 Puerto Rico would likely seek federal help if the Commonwealth defaulted. Federal involvement would necessitate a debate regarding the island’s legal status. Some Americans might support Puerto Rican statehood and a financial “bailout” in exchange for fiscal reforms. Others might seek to sever political ties with the island, altogether.
4 See Fox News Latino, “Puerto Rico Primary Gives a Push to Luis Fortuno’s Statehood Bid,” March 19, 2012. Available at: http://latino.foxnews.com/latino/news/2012/03/19/puerto-rico-primary-gives-push-to-luis-fortunos-statehood-bid/
5 See “Trends and Developments in the Economy of Puerto Rico, Federal Reserve Bank of New York, “Current Issues,” Vol. 14, No. 2 (March 2008)
6 Interest paid on Puerto Rico bonds is not taxed by federal, state, or local governments. This leads to a low cost-of-capital for the island nation.
7 Prior to 2006, foreign corporations operating in Puerto Rico could claim a large tax credit under section 936 of the federal tax code. Known as the “possession tax credit,” the favorable tax treatment drew many chemical and pharmaceutical manufacturers to the island. According to the Federal Reserve Bank of New York, more than 4% of the island’s private sector workers are employed in the pharmaceutical industry. This is more than 10 times the mainland average. See “Trends and Developments in the Economy of Puerto Rico, Federal Reserve Bank of New York, “Current Issues,” Vol. 14, No. 2 (March 2008).
8 Transfer payments include those for social security and food stamps, among others. They are a significant part of Puerto Rico’s economy. In 2009, 32% of the federal government’s food stamp payments went to Puerto Rico. The island nation represents less than 1.3% of the U.S. population.
9 See 2006 Center for the New Economy report. Available at: http://www.grupocne.org/information_bank/FLMM.pdf
10 This compares to 45% in the U.S. See: United States Bureau of Labor Statistics and Puerto Rico Department of Labor and Human Resources. Data available at: http://www.grupocne.org/information_bank/FLMM.pdf.
11 See 2006 Center for the New Economy report (March 2007). Available at: http://www.grupocne.org/information_bank/FLMM.pdf. See slides 24 - 26.
12 See UBS Wealth Management Research, Municipal Report Commonwealth of Puerto Rico (January 11, 2012). See also: March 7, 2012 Official Statement for Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2012A, p. 4. Available at: http://emma.msrb.org/EP611148-EP478117-EP878493.pdf. The Commonwealth reports a lower FY 2012 deficit in the Official Statement because it excludes $685 million in refinanced debt service from its calculation. Most financial analysts would include the refinanced amount. See the UBS report and the Center for the New Economy website note, available at: http://grupocne.org/cneblog/?p=831.
13 See Government Development Bank (GDB) Statistical Appendix of the Economic Report for the Governor and Legislative Assembly, Tables 3 and 29, available at: http://www.gdbpr.com/economy/statistical-appendix.html.
14 See Government Development Bank (GDB) Statistical Appendix of the Economic Report for the Governor and Legislative Assembly, Tables 3 and 29, available at: http://www.gdbpr.com/economy/statistical-appendix.html. See also March 7, 2012 Official Statement for Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2012A, p. I-56. Available at: http://emma.msrb.org/EP611148-EP478117-EP878493.pdf
15 Figure includes debt guaranteed by the Commonwealth and revenue bonds. See: Puerto Rico’s FY 2010 Comprehensive Annual Financial Report, pp.137.
16 Most Puerto Rico bonds are held by mainland U.S. residents who are attracted to the island’s “triple-tax-free” interest payments. Affluent residents of New York City often find the bonds particularly attractive because they face high marginal city, state, and federal income tax rates.
17 See Government Development Bank data and official statements from latest bond offerings.
18 For example, in February 2012, the Governor of Puerto Rico pointed to a modestly improved economic report as evidence that the island’s recession was over. His statement ignored the fact that economic growth, as measured by the Government Development Bank, actually declined on a month-over-month basis. See “Puerto Rico’s recession is over, Governor says,” Feb. 21, 2012, Reuters. Available at: http://www.reuters.com/article/2012/02/21/puertorico-economy-idUSL2E8DLFKI20120221. The GDB’s January 30, 2012 Economic Indicators report showed that the Commonwealth’s “Economic Activity Index” finished at 128.2 in November 2011 compared to the December 2011 figure of 127.7. See: http://www.gdbpr.com/economy/GDB-Economic-Activity-Index.html.
19 At the end of fiscal year 2010, the Commonwealth’s public corporations owed $607 million to the primary government, and $3.6 billion to each other. During that year, the primary government expensed $2.7 billion in payments to the Commonwealth’s major public corporations. The Commonwealth’s primary government budget is roughly $20.7 billion. One expert, Sergio Marxauch, has noted that: “… the Byzantine structure of our government, with its manifold executive departments, has generated a complete lack of accountability, oversight, and transparency in government operations…” See: 2006 Center for the New Economy report. Available at: http://www.grupocne.org/information_bank/FLMM.pdf.
20 See Puerto Rico’s FY 2010 Comprehensive Annual Financial Report, pp. 120 – 125.
21 See Municipal Market Advisors, Weekly Outlook, April 2, 2012.
22 In FY 2010, $2.3 billion of the GDB’s public sector loans were delinquent by 90 days or more, an amount equal to 27% of the GDB’s “loans receivable.” This figure is up from $510 million in FY 2006. Delayed loan collection is one reason the bank’s net interest margins (interest earned on lending less interest paid on borrowings) are low. See the following sources: Official Statement, Government Development Bank for Puerto Rico, Senior Notes, Series 2011A and 2011B, December 21, 2011, pp. 10 and 25; Official Statement, Government Development Bank for Puerto Rico, Senior Notes, Series 2006A, February 8, 2006, p. 29; and Standard & Poor’s January 27, 2011 rating opinion for The Government Development Bank for Puerto Rico.
23 Instead, the Commissioner of Financial Institutions of Puerto Rico performs audit examinations of the bank every 18 months. See Standard & Poor’s January 27, 2011 rating opinion for Government Development Bank for Puerto Rico.
24 The bank has fiscal oversight agreements with the Highways and Transportation Authority, the Puerto Rico Aqueduct and Sewer Authority (PRASA), the Electric Power Authority, the Ports Authority, the Puerto Rico medical Services Administration, and the Puerto Rico Health Insurance Administration. It also has a fiscal oversight-type agreement with the University of Puerto Rico. See: Official Statement, Government Development Bank for Puerto Rico, Senior Notes, Series 2011A and 2011B, December 21, 2011.
25 See Puerto Rico’s FY 2010 Comprehensive Annual Financial Report, pp. 196.
26 See March 7, 2012 Official Statement for Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2012A, p. I-56. Available at: http://emma.msrb.org/EP611148-EP478117-EP878493.pdf. However, note that Moody’s reports suggest a slightly brighter picture. Moody’s believes recent reforms have extended the life of Puerto Rico’s pension funds by roughly six years. See Moody’s Investors Service, Issuer Comment, “Key Drivers of Puerto Rico’s Downgrade to Baa1,” August 10, 2011. At that time, Moody’s expected pension reforms to extend the life of the ERS from 2019 to 2025.
27 Acts 7, 154, 171.
28 Act 161.
29 Act 7.
30 Act 29.
31 Acts 114, 116.
32 See Government Development Bank data. Available at: http://www.gdbpr.com/economy/GDB-Economic-Activity-Index.html.
33 The Commonwealth received a lump sum payment of $1 billion as part of a toll road leasing agreement in September 2011. See March 7, 2012 Official Statement for Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2012A, p. I-31. Available at: http://emma.msrb.org/EP611148-EP478117-EP878493.pdf.
34 See Report by the Joint Committee on Taxation, “An Overview of the Special Tax Rules Related to Puerto Rico and An Analysis of the Tax and Economic Policy Implications of Recent Legislative Options,” June 23, 2006. Available at: http://www.jct.gov/publications.html?func=startdown&id=1496.
35 Mutual funds own Puerto Rico because it comprises 4% of the Barclays’ municipal market index, and 50% of the BBB portion of that index. Most funds are benchmarked to the performance of these indexes. See: Barclay’s Municipal bond Index, March 27, 2012. Note also that the $60 billion figure is from the Government Development Bank (GDB) Statistical Appendix of the Economic Report for the Governor and Legislative Assembly, Table 29, available at: http://www.gdbpr.com/economy/statistical-appendix.html.
36 Breckinridge analysis of Bloomberg data, 3/23/2012.
37 For example, Assured Guaranty has at least $4.8 billion in exposure to Puerto Rico, and the island’s debt also comprises six of the top 10 exposures for Financial Guarantee Insurance Company (FGIC). See: Assured and FGIC’s statutory statements, December 2011.
38 See 11 USC 101(52).
39 Congress is given broad powers under the Territorial Clause of the U.S. Constitution. See: Sergio Marxauch, “Municipal Fiscal Crises in the United States: Lessons and Policy Recommendations for Puerto Rico,” Center for the New Economy, April 28, 2006, p. 15
40 See Sergio Marxauch, “Municipal Fiscal Crises in the United States: Lessons and Policy Recommendations for Puerto Rico,” Center for the New Economy, April 28, 2006, p. 15.
41 Section 8, Article VI of the Constitution of Puerto Rico gives general obligation bondholders a first claim on all available Commonwealth resources. However, math and the threat of public disorder have a way of bending seemingly ironclad clauses in state constitutions. For example, the Commonwealth might argue that its debts are merely those of a federal territory and that bondholders have limited legal recourse against a federal government sovereign – including its territories. This would be a novel approach, but it might work in conjunction with a federal bailout. Importantly, Puerto Rico has already demonstrated a willingness to restructure contracts to ameliorate its financial situation. Last year, the Commonwealth successfully abrogated a collective bargaining agreement on the grounds that it was reasonable and necessary to tear-up the contract. See: United Automobile, Aerospace, Agricultural Implement Workers of America International Union, et al. v. Luis Fortuno, et al., 633 F. 3d 37 (January 27, 2011)
42 The Commonwealth’s most senior debt obligations are its general obligation bonds and its COFINA bonds. COFINA bonds are sales tax backed bonds that are, at least theoretically, insulated from general fund obligations. Puerto Rico’s general obligation bondholders have long been secured by the Commonwealth’s “available” resources, including its taxing power. But when COFINA bonds were created, lawmakers deemed the sales taxes that backed them as “unavailable” resources.
43 Prior courts have ruled that local governments may carve out specific “available” revenues to the detriment of pre-existing general obligation bondholders. In fact, “dedicated tax” bonds are routinely issued across the country. However, Puerto Rico’s COFINA bonds were issued in a time of distress, arguably to the detriment of general obligation bondholders. Also, the only case we know of in which a carve-out was upheld against a general obligation bondholder involved a tax increment financing district. In that case, the pledged revenue was never made available for general fund operations. COFINA bonds are supported by a sales tax, half of which flows back to the general fund. This fact may have implications for the strength of the COFINA bonds’ dedicated tax pledge. The tax increment financing case is: Wolper v. City Council of City of Charleston, 287 S.C. 209, (1985).
44 See N.J. Educ. Ass'n v. New Jersey, 2012 U.S. Dist. LEXIS 28683.
45 See Porto Rico v. Ramos, 232 U.S. 627 (1914).
46 Puerto Rico’s constitution certainly implies that the Commonwealth has waived its sovereign immunity defense. However, the language in Puerto Rico’s Constitution is more vague than language used by U.S. states. Puerto Rico’s Constitution provides in Article VI, Section 2: “The Secretary of the Treasury may be required to apply the available revenues including surplus to the payment of interest on the public debt and the amortization thereof in any case provided for by Section 8 of this Article VI at the suit of any holder of bonds or notes issued in evidence thereof” (emphasis added). It is unclear from this language whether Puerto Rico’s Constitution refers to suits in Puerto Rican courts or in Federal courts. The U.S. Supreme Court has held that sovereign immunity rights are waived only when “the waiver is stated by the most express language or by such overwhelming implication from the text as will leave no room for any other reasonable construction.” See: In re Creative Goldsmiths of Washington, D.C., Inc., 119 F. 3d 1140 (4th Cir. 1997), at 1147. In other bond indentures, we often see a clearer statement of intent that includes words like “sovereign immunity,” “waiver,” or “governmental immunity,” among others.






 

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