This blog post continues our coverage of the Puerto Rico municipal bond crisis.
Puerto Rico had a successful $3.5 billion issue of municipal general obligation bonds (“GOs”) in March 2014. However, as we outlined in our February 2014 paper “The Puerto Rico Municipal Bond Crisis: What took you so long?”, the macroeconomic fundamentals of the Puerto Rican economy remain extremely poor. Despite reform efforts by the Padilla administration, the situation reached a new crescendo last week as the Puerto Rican legislature passed “The Puerto Rico Public Corporation Debt Enforcement and Recovery Act” ("Act 71") on June 28, 2014.
The Police Power Doctrine
Act 71 follows closely behind Act 66 passed on June 17, 2014, “The Special Act for Fiscal Sustainability and Operational Government of the Commonwealth of Puerto Rico,” which declared the island in state of “fiscal emergency” following the downgrades. Importantly, this declaration of a fiscal emergency allows the Commonwealth to invoke its constitutional “police power” to protect basic services, which is the major legal justification invoked within Act 71. The following is a summary of Act 71 as well as selected general context information.
Puerto Rico’s Public Corporations
Puerto Rico has three main public corporations:
- the Puerto Rico Electric Power Authority (“PREPA”);
- the Puerto Rico Aqueduct and Sewer Authority (“PRASA”), and;
- the Puerto Rico Highways and Transportation Authority (“PRHTA”).
Originally thought to be relatively secure investments due to the guaranteed cash flows inherent in utilities, the public corporations have suffered a series of downgrades on the heels of the GO downgrade earlier in the year.
Because of their roles providing essential public services, the specter of default of the public corporations is acutely important to the Puerto Rican government. An easy solution to raise revenue would be to simply further raise rates; however, the government has disallowed this due to the already precarious economic situation.
As we have discussed here, in June 2014 both Fitch and S&P downgraded PREPA’s credit rating to BB and BBB-, respectively. In addition, Moody’s issued a stern rebuke to the passage of the law citing concerns about the impact the precedent would have on creditors, issuing a series of downgrades just days after the passage of Act 71. Moody’s slashed GO ratings from Ba2 to B2, and also downgraded the Puerto Rico Sales Tax Financing Corporation (“COFINA”) from Baa1 to Ba3, throwing the COFINA bonds into junk territory. Moody’s also downgraded PREPA from Ba3 to Caa2 and downgraded PRHTA from Ba3 to Caa1.
Structural Issues 
As cited in the law itself, Puerto Rico remains in the grip of serious structural problems. Public deficits remain high, and despite the halving of general deficits from over $2.2 billion projected for 2012-2013 to $1.29 billion in June 2013, revenues remain insufficient. As of June 10, 2014, collections were $320 million below projections for the current fiscal year.
The public corporations are also running deficits. For fiscal year 2012-2013, PREPA, PRASA, and PRHTA had a combined deficit of $800 million and combined debt of $20 billion. Despite numerous reforms, some rate increases and various specific solutions, in total the measures taken have proved insufficient. As of July 2014, Puerto Rico GOs, PREPA, PRASA, PRHTA, the Public Buildings Authority, COFINA, and the Government Development Bank of Puerto Rico (“GDB”) have all been downgraded to junk.
The plight of the public corporations is caused by a number of persistent issues, including (as Act 71 cites): “…budget deficits incurred over decades, prolonged economic recession (since 2006), a high rate of unemployment that reached 16 percent in 2010, population decline, and high levels of debt and pension obligations…” These factors represent deep structural problems that cannot be easily or quickly addressed.
The Government Development Bank of Puerto Rico
The downgrade of the GDB has had serious repercussions. In its role as chief financial advisor and fiscal agent to the Commonwealth and its municipalities, instrumentalities, and public corporations, the GDB had served as the main source of interim lines of credit for both the central government and the public corporations during the recent adverse economic environment. For the fiscal year ended June 30, 2013, 48 percent of the GDB’s assets, or $6.9 billion, are in loans to the Commonwealth and the public corporations. The GDB’s ability to continue to extend lines of credit to Puerto Rico’s public entities going forward is compromised by the downgrade, and thus the legislature has been forced to take additional action to avoid default.
Act. 71 - The Puerto Rico Public Corporation Debt Enforcement and Recovery Act
The stated goal within the preface of the Act is: “…to establish a debt enforcement, recovery, and restructuring regime for the public corporations and other instrumentalities of the Commonwealth of Puerto Rico during an economic emergency.” Public corporations fall in a legal grey area. Prior to Act 71, no Commonwealth law existed to govern a public corporation that became insolvent. Furthermore, U.S. Federal bankruptcy law does not apply. Just as cities may go bankrupt under federal bankruptcy law but states may not, Puerto Rico may not seek federal bankruptcy protection, and its public corporations are also exempt.
Two Paths to Debt Relief
The law sets up two mechanisms for an insolvent public corporation to utilize: Chapter 2 outlines a consensual debt modification with a binding recovery program, and Chapter 3 outlines a court-supervised debt enforcement plan. The Act also sets up the Public Sector Debt Enforcement and Recovery Act Courtroom of the Court of First Instance, San Juan Part, to hear and process all claims in the timeliest manner.
Chapter 2 
Chapter 2 outlines a market-oriented framework for the public corporations, with the stated goal of treating all creditors equally unless a creditor agrees to be treated less favorably. Chapter 2 begins with the request of the governing body of the corporation and the GDB, or the GDB at the Governor’s request, and includes any combination of amendments, waivers, maturity extensions, and other debt relief measures so long as the corporation agrees to be bound by a recovery program designed to return it to self-sufficiency. All amendments must be approved by a majority of eligible holders within a class and a three-quarters majority of eligible holders of all aggregate debt. If approval is won, the measures are submitted for court approval to ensure that they fulfill the objectives of Act 71. Furthermore, an oversight commission of three independent experts shall be appointed by the Governor to monitor compliance and disclose progress to stakeholders.
Chapter 3 
Chapter 3 outlines a judicial-oriented framework for the public corporations similar to Chapters 9 and 11 of Title 11 of the U.S. Federal Code, tasking the court with using appropriate jurisprudence. Chapter 3 enables the public entities to defer debt obligations as necessary to continue to fulfill their public functions. Notably, “Assets backing employee retirement or post-employment benefit plans remain inviolable under Chapter 3.” Additionally, wages, salaries, provisions for goods and services under at least $1 million, and debts to the United States are mandated paid in full.
An eligible entity must be 1) currently unable or at serious risk of being unable to pay valid debts while performing public functions, 2) ineligible for relief under Chapter 11 of Title 11 of the United States Code and 3) authorized to file a petition by its governing body and the GDB or by the GDB at the Governor’s request. An entity under Chapter 3 retains possession and control of its assets and operations. Contracts may be modified or rejected, and any counterparties with breach of contract standing will be treated accordingly under the final plan. Collective bargaining agreements may be modified or rejected, but only if the Court determines that such changes are necessary for the corporation to continue to carry out its public functions. Additionally, collective bargaining agreements may only be changed after the underlying data has been shared with union representatives and voluntary negotiations have failed.
The petitioner or the GDB (under the Governor’s request) may propose a debt enforcement plan under Chapter 3. Creditors must be separated into classes, and each creditor must receive 1) at least the value they would receive if all creditors simultaneously enforced their claims individually, and 2) notes providing additional value calculated as 50 percent of the public corporation’s future positive cash flow for 10 years. Approval of any plan requires one class of debt to accept the terms, but all classes may be treated as described in Chapter 3 regardless if they accept the plan.
Exempt Entities 
Notably, many entities are explicitly unable to restructure under Act 71. Any government entity not explicitly excluded is eligible under Act 71. Exempt entities include:
- The Commonwealth, including GO debt and debt guaranteed by the Commonwealth
- All 78 municipalities
- The GDB and its subsidiaries, affiliates, and ascribed entities
- The Children’s Trust
- The Employees Retirement System
- The Judiciary Requirement System
- The Municipal Finance Agency and the Municipal Finance Corporation
- The Puerto Rico Industrial Development Company
- The Puerto Rico Industrial, Tourist, Educational, Medical and Environmental Control Facilities Financing Authority
- The Puerto Rico Infrastructure Financing Authority
- The Puerto Rico Sales Tax Financing Corporation
- The Teachers Retirement System
- The University of Puerto Rico
While GO debt may be exempt from restructuring under Act 71, the markets are nervous about a newly emboldened Puerto Rico government that may try to find a way out of those obligations. Chart 1, below, shows the continuing steep decline in the S&P Municipal Bond Puerto Rico Index, which contains primarily GO bonds.
Chart 1. S&P Municipal Bond Puerto Rico Index
For a higher resolution image, see this.
Accelerant analyst Jay Dulski wrote this blog post and continues to follow the Puerto Rico story closely.
For information about Accelerant municipal bond and closed-end fund experts Gerry Guild, Steve Pomerantz, and John Duval, Sr., click here.
 Reuters, June 18, 2014, “UPDATE 1-S&P lowers Puerto Rico Electric debt rating, follows Fitch,” http://www.reuters.com/article/2014/06/18/sp-ratings-puertorico-idUSL2N0OZ19J20140618
 Wirtz, Matt, Jule 1, 2014, “Moody’s Cuts Puerto Rico Rating Three Notches” http://online.wsj.com/articles/moodys-cuts-puerto-rico-rating-three-notches-1404241559
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