What are the legal consequences of Puerto Rico not paying bondholders? Can Puerto Rico be sued? In which Court? Who can sue? All these are important questions for investors and the general public after Standard & Poor’s and Moody’s downgrades, which include the latter’s actions on the COFINA backed bonds.  Here, I will try to predict the possible scenarios.

The most obvious is that PR, nor any state of the Union, can file for US Bankruptcy law protection for the Code does not provide fro them to do so. In addition, none of PR’s municipalities or public corporations may do so. Not only does PR law expressly allow it, but 11 U.S.C. § 101(52)  expressly excludes PR and Washington DC from Chapter 9 protection. Hence, the organized reorganization that Detroit is undergoing is not possible for PR.

Puerto Rico is not an independent country nor is it a state of the Union. It is a self-governing non-incorporated territory of the United States, see, Harris v. Rosario, 446 U.S. 651 (1980). But for purposes of the Eleventh Amendment, it is a state, see, Fresenius Medical Care Cardiovascular Resources, Inc. v. Puerto Rico and the Caribbean Cardiovascular Center Corp., 322 F.3d 56, 61 (1st Cir. 2003). This Amendment was incorporated on the heels of Chisom v. Georgia, 2 U.S. (2 Dall.) 419 (1793), which decided that a state of the Union could be sued in Federal Court, even if it could not in its own courts. Soon after, the Eleventh Amendment was enacted and approved. Hence, PR cannot be sued in Federal Court without its consent.

PR has given its consent to be sued in its own courts for breach of contract, see, Hato Rey Stationery, Inc., v. Commonwealth of Puerto Rico, 19 P.R. Offic. Trans. 153 (1987)  and Montalvo & Comas Electric Corp. v. Commonwealth of Puerto Rico, 7 Offic. Trans. 613 (1978). The inquiry, however, does not end there.

Although it is usually agreed that PR owes around $70 billion, not all of the debt is owed by the Commonwealth of Puerto Rico, the official name of the island’s government. According to slide 56 of The Commonwealth of Puerto Rico,  Update on Fiscal and Economic Progress, FY 2014 Q1 Investor Webcast – October 15, 2013 , has a general breakdown of who owes what. This brings several issues to bear. Public corporations such as the PR Electric Power Authority that generate their own income are subject to federal court jurisdiction and these owe around $25 billion. In addition, municipalities owe over $3 billion and are not protected by the 11th Amendment. Moreover, only $16.233 billion which is GO debt backed by the full faith and credit of PR are Constitutionally protected and are required to be paid before anything else, see, Article VI, sections 2 and 8 of Puerto Rico’s Constitution, available here in English.

Hence, the bond holder or the insurance company that subrogates on its insured’s rights, has to examine who is the issuer of the debt, what if any 11th Amendment protection it may have and then determine where to sue for collection of moneys.

This does not mean that bond holders or their agents or subrogees will collect from PR. The island may unilaterally change the conditions of the contract. The guarantee against the impairment of contracts provided by the Contract Clause of the US and Puertorrican Constitution have been greatly eroded in the past years. This can be seen in United Auto., Aerospace, Agr. Implement Workers of America Intern. Union v. Fortuño, 633 F.3d 37 (1st Cir. 2011); Trinidad v. ELA, 2013 TSPR 73 and Domínguez Castro et al. v. E.L.A. I, 178 D.P.R. 1 (2010), cert denied, Domínguez Castro v. Puerto Rico, 131 S. Ct. 152  (2010).  This means that it is very likely that a court could conclude that PR may put a temporary moratorium or even repudiate part of its debt or that of its political subdivisions. Such a step would be radical and I doubt if the present administration would even consider it, but it is there to consider.

Desenmascarando Los Comunicados de Fortaleza

El 5 de febrero de 2014, Standard & Poor’s degradó del crédito de PR a chatarra, BB+ y el de Banco Gubernamental de Fomento a BB. El gobernador García Padilla hizo una conferencia de prensa, dijo que su administración “no era responsable” y no proveyó información de lo que su administración haría sobre ello. Hoy, Moody’s fue más allá y degradó el crédito de PR dos escalafones, a chatarra. Bajó también de clasificación los bonos de Cofina, garantizados por fondos del IVU, cosa que S&P no había hecho.

En ambos casos, Fortaleza insiste que hizo todo lo que le dijeron que hiciera, que la degradación “era injusta con PR”. A continuación tienen una tabla comparativa de lo que dijo Moody’s en el 2012 y lo que dijo ahora en el 2014.

Very large unfunded pension liability relative to revenues that we expect will claim an increasing share of the budget over the medium term Very large unfunded pension liabilities relative to revenues, even after major reforms to two main plans that helped reduce cash-flow pressure
Very high and growing government debt relative to the size of the economy, due in part to financing budget deficits Very high government debt, equal to more than 50% of gross domestic product
High unemployment, low workforce participation, and high poverty levels compared to the US; average income levels remain well below 50% relative to the US mainland median Ongoing economic weakness due to long-term decline in dominant manufacturing sector, decreased competitiveness as a result of expired federal tax benefits, and high energy costs
Declining population Dependence on capital markets financing to fund operating expenses and debt service during period of increased risk of reduced market access
Large size of commonwealth government relative to the economy (although recent government actions are reducing the size of the government employment sector) Multi-year trend of large general fund operating deficits relative to revenues, financed by deficit borrowing
Local economy that has been in recession since 2006
Significant improvement in the condition of the commonwealth’s pension system.
Strong rebound in economic growth leading to improved and sustained revenue results. Strong rebound in economic growth leading to improved and sustained financial performance
Spending controls and/or revenue increases that lead to long-term improved budgetary results and outlook. A trend of declining debt
Reversal of General Fund’s deficit position.
Lack of liquidity Evidence of further constraints on market access or significant further weakening of GDB liquidity
Lack of market access
Indication that total fixed costs, including pension contributions and debt service on bonded debt, have become unsustainable or unaffordable. Indication that total fixed costs, including pension contributions and debt service on bonded debt, have become unaffordable
Steep growth in structural budget gap and an increase in GAAP deficits, solved with non-recurring solutions. Steep growth in structural budget gap and an increase in GAAP deficits, solved with non-recurring solutions
Further recession, resulting in declining revenues, deficit financing and continued out-migration Economic weakness resulting in declining revenues and continued out-migration
Inability to curtail increase in debt experienced in recent years. Reacceleration of growth in government debt

Como podemos ver, los temas se repiten.  Lejos de hacer todo lo que las acreditadoras le pidieron, AGP nada hizo. Su reforma de los sistemas de retiro no proveyó fondos suficientes para que las acreditadoras piensen que  los fondos de retiro tienen suficiente dinero para pagar sus obligaciones sin inyecciones adicionales. La economía no ha crecido ni ha habido una baja en la deuda. Han surgido reportes que AGP ha tomado prestado $1.9 billones a bancos, con un interés bien alto, lo que no tiene que ser reportado a las agencias reguladoras. Más aún, personal de S&P dijo que tomó la decisión de degradar el crédito de la isla por información confidencial del Banco Gubernamental de Fomento. Esto solo pudo haber sido información negativa a la liquidez del Banco, nuevamente violando lo dicho por las acreditadoras.

¿Que demuestra eso? Que AGP no tiene idea de lo que tenía que hacer. Peor aún, no tiene idea de lo que tiene que hacer. El mensaje de hoy esta lleno de indeterminadas generalidades y nimiedades, que pueden dar paso a cualquier cosa. Así no se enfrentan las crisis. Debió decir “voy a reducir los Municipios a tantos, eliminar tales agencias y consolidar sus funciones con tales agencias, nadie podrá ganar más de tanto y cada Secretario tendrá 2 ayudantes y los subsecretarios ninguno. Los legisladores igual. “ Las degradaciones continuarán hasta que PR elija al verdadero líder que Alejandro no es.