Puerto Rico could seek to invalidate over $4 billion in debt

An audit report published on Thursday suggests that debt-laden Puerto Rico may be able to void some of its borrowing because politicians exceeded constitutional debt limits and their own authority.

The report, shared with MarketWatch, states that some of Puerto Rico’s debt may have been issued illegally, allowing the government to potentially declare the bonds invalid and courts to then decide that creditors’ claims are unenforceable. The scope of the audit report, issued by the island’s Public Credit Comprehensive Audit Commission, covers the two most recent full-faith-and-credit debt issues of the commonwealth: Puerto Rico’s 2014 $3.5 billion general-obligation bond offering and a $900 million issuance in 2015 of Tax Refund Anticipation Notes to a syndicate of banks led by J.P Morgan JPM, +0.18%  .

Money for those debt payments is not in the commonwealth’s proposed budget, either. On Tuesday Puerto Rico’s governor, Alejandro García Padilla, sent a proposed 2016-17 budget to the island’s legislature that provides for only $209 million of the $ 1.4 billion of current debt-service cost. As García Padilla told reporters at a news conference: “This is simple: either we pay Wall Street or we pay Puerto Ricans. If the legislature decides we pay Wall Street more, well, each has his responsibility. I will continue defending Puerto Ricans. Money I send to Wall Street, I do not have to provide services here.”

Puerto Rico defaulted May 1 on a portion of its $72 billion in outstanding debt, but the commission’s audit covers two debt issues expected to default on July 1. The report’s conclusions may allow the commonwealth to pursue a strategy with even more dire consequences for bondholders. The commission’s report says that Puerto Rico may have violated its constitution by borrowing to finance deficits, borrowing beyond its debt ceiling and using a refinancing technique called the “scoop and toss” to effectively exceed bond-duration limits.

Also read: Puerto Rico bill would allow probe into bond sales

The Puerto Rican constitution contains a balanced-budget clause that explicitly prohibits borrowing to finance operating deficits, but its politicians borrowed to cover deficit financing in its 2014 General Obligation Bond Offering, according to the commission’s initial review. The March 2014 General Obligation Bond states that the proceeds would be used in part to cover deficits that had accumulated and that were expected to occur in the year of the offering. The documents include a chart showing deficits financed with borrowing during the past and that were expected to recur.

In addition, Puerto Rico did not inform bondholders that its constitution forbids it from using debt to finance deficits. That, the commission’s report says suggests “substantive” noncompliance with the letter of the constitution.

The U.S. Supreme Court has said in the Litchfield v. Ballou case and, more recently, in litigation related to Detroit’s bankruptcy that borrowing above a debt ceiling may allow the issuer to declare debt invalid and, therefore, unpayable. Detroit went to court to invalidate $1.45 billion in certificates of participation, debt issued by two shell companies called “service corporations.” The parties settled before the case went to trial, but, while refusing two initial proposed settlements, the judge stated that Detroit’s argument had “substantial merit” and that the suit would have had a “reasonable likelihood of success.”

Melissa B. Jacoby, a professor of law at the University of North Carolina who specializes in distressed debt, noted that the negotiations have been complicated by claims that certain bonds are special and have priority over debt held by other creditors. “But if some debt was issued illegally, then, at the very least, those creditors’ claims of priority are dramatically weakened,” said Jacoby. “Indeed, they would be lucky to get anything at all.”

The audit commission includes 17 members including elected officials, representatives of the financial institutions, credit unions, academics and organized labor.

Bipartisan legislation cleared a House committee last week that would create a debt-restructuring authority for Puerto Rico, combined with independent fiscal oversight to address the crisis. The bill is expected to get a vote in the full House in early June.

By

FrancineMcKenna

Puerto Rico could seek to invalidate over $4 billion in debt