What Puerto Rico’s New Bankruptcy Law Means for Debt Holders

On June 29^th, 2016 Congress passed the “Puerto Rico Oversight, Management and Economic Stability Act,” otherwise known as PROMESA. PROMESA was signed by the President June 30^th, 2016. Mere hours later, in a surprise to absolutely no one, Puerto Rico’s Governor Padilla (made good on his threat / promise) defaulted on $1.9 billion of debt (of the $72 billion outstanding) that was due July 1, 2016.

The $1.9 billion included $800 million owed on general obligation bonds, which – prior to the passage of PROMESA – were contractually required by the Constitution of Puerto Rico to be paid first, ahead of all other debts, salaries, pensions or services of Puerto Rico.

Not at all coincidentally, PROMESA included a provision effective upon enactment that provides an automatic stay against legal action from creditors, where the stay may not be treated as a default under existing contracts or laws. The stay lasts until at least February 15, 2017, though can be extended under multiple conditions and circumstances. The automatic stay of legal action by creditors is part of the normal federal Bankruptcy Code, effective once the petition for bankruptcy is filed.

The territorial government and municipal issuers of Puerto Rico did not previously have the ability to declare bankruptcy or restructure their debts under federal bankruptcy law. Nor did the bond contracts for the general obligation bonds provide a mechanism such as collective action clauses (CACs) to allow for binding negotiation given a super-majority of creditors in the event of default. Among the provisions in PROMESA are Titles that provide for a municipal-like bankruptcy scheme (similar to chapter 9) and debt restructuring under business reorganization (similar to chapter 11) for the territory, effectively overriding the protections in the bond indentures under which the debt was issued.

Kind of stinks for bondholders, huh?

Not a banner day for contract law, but savvy bondholders knew it was coming. Several groups of investors – including most politician’s and financial commentator’s favorite villain, the “hedge funds” – have been lobbying against PROMESA for a couple of years now. They may not like the outcome, but this is how our legislative system works. Don’t like existing legal recourse or remedy? Pass new law that supersedes it. And Congress did, by a relatively wide margin in a truly bipartisan vote.

PROMESA (H.R. 5278, and S. 2328)

·       Passed in the House on June 9, 2016, by a vote of 297-127.

·       Passed in the Senate on June 29, 2016 by a vote of 68-30.

Is there any contagion risk?

None that appears evident right now. The Commonwealth of Puerto Rico, as a territory of the U.S., makes the resolution and depth of its fiscal crisis somewhat unique. PROMESA is written so that its scope and provisions would apply to other U.S. territorial governments, and instrumentalities of those territorial governments, that find themselves in dire financial circumstances. However, other territories of the U.S. such as Guam and the U.S. Virgin Islands, for instance, are certainly troubled but nowhere near experiencing the fiscal and economic distress that has been decades in the making in Puerto Rico. Therefore the broader applicability of PROMESA is quite limited, and perhaps unlikely. Your muni bond trader and analyst can provide up to date commentary, analysis and trading volumes for similarly situated debt.

A Punctuated Overview

PROMESA establishes a seven-member Financial Management and Oversight Board which will have broad (some might say vast) powers of oversight and enforcement to:

·       Adopt and approve fiscal plans;

·       Balance and manage the budget;

·       Negotiate voluntary agreements with bondholders; and

·       Execute debt restructuring plans.

Wow. How are the seven Oversight Board members chosen and how long do they serve?

·       The President is allowed to appoint one Board member entirely at his own discretion.

·       Congressional leaders will submit lists for the other six, some of whom are required to either be residents of, or do business in, Puerto Rico. The President can either choose candidates off the lists, or appoint others; though anyone not on one of the Congressional lists would be subject to Senate confirmation.

·       If all appointments are not made by September 1^st, the President will be mandated to choose nominees for the remaining vacancies from the lists by September 15^th, 2016.

·       The governor of Puerto Rico, or a designee, will serve on the Board as an ex-officio, non-voting eighth member.

·       The Board members are to serve concurrent three-year terms, and can continue to serve another three-year period until a successor has been appointed.

·       The Board members are unpaid, though normal expenses will be reimbursed.

What conditions have to be met for the Oversight Board to be disbanded?

The Oversight Board will terminate when the territorial government has:

1.       Access to short-term and long-term credit markets at reasonable rates of interest; and

2.       Achieved balanced budgets for four consecutive years.

So it’s like, indefinite? Possibly so. Access to the credit markets can likely be achieved once the debt restructuring process is successfully completed (see: Argentina). Balancing the budget for four consecutive years is going to complicate the debt restructuring, and is likely to cause further political upheaval and economic distress, at least in the short term.

How would the debt restructuring work?

The following are excerpts, with some paraphrasing, from an excellent June 27^th, 2016 overview of PROMESA by Andrew Austin of the Congressional Research Service (formatting and emphasis added, minor edits).

Title III of PROMESA sets up a process for the adjustment of debts of a territorial government or an instrumentality of a territorial government. The following are a few salient features of such a process:

·       Eligibility for a debt restructuring requires agreement of at least five of the seven members of the Oversight Board.

·       Unlike in municipal bankruptcy (chapter 9) or business reorganization (chapter 11) of the federal Bankruptcy Code, the role of filing the petition with the district court and proposing a debt restructuring plan is taken on by the Oversight Board, not by the debtor.

·       Otherwise, many of the provisions in Title III are similar to chapters 9 and 11 of the Bankruptcy Code.

·       The debt restructuring process is set up to ensure fair and equitable treatment of creditors.

Title VI would create a process for creditor collective actions, which resemble collective actions clauses (CACs) that are a common feature of sovereign debt contracts.

·       CACs typically allow some subset of creditors holding a supermajority of the face value of a given debt category to enter into an agreement that would bind remaining creditors within that category.

·       Title VI would require the Oversight Board, in consultation with the Puerto Rico government and its subunits that have outstanding debts, to set up voting pools for the CAC process. Separate pools, in general, would correspond to the relative priority or security arrangements of bondholders.

·       Triggering the Title VI CAC provision for a voting pool would require a two-thirds vote (by value of eligible debt), in which holders of at least half of the eligible debt participated.

·       Creditors in those voting pools not assenting to a modification agreement would retain certain rights, which might be affected by a subsequent Title III debt restructuring.

·       Creditors agreeing to a Title VI CAC provision, in general, would then avoid Title III debt restructuring.

The bill would allow the Oversight Board to obtain information on the nature and aggregate amount of claims held by each creditor or organized group of creditors from those creditors seeking to participate in voluntary negotiations regarding debt restructuring.

Most importantly, the bill would grant an Oversight Board, at its sole discretion, the power to certify voluntary debt restructuring agreements entered into between the territory or territorial instrumentality and holders of its debt instruments. Upon review of such an agreement, the Oversight Board must certify that the agreement provides for a sustainable level of debt and is in conformance with the territory or territorial instrumentality’s certified Fiscal Plan. The act would grandfather in voluntary agreements executed before its enactment.

What are the options in a debt restructuring?

The debtor typically proposes options that include some or all of the following:

·       A decrease in the coupon of outstanding debt, effectively lowering the interest payments;

·       An increase in the time to maturity;

·       A lowering of the principal amount owed (often referred to as “cram down” of the debt holders);

The recovery rate is then the ratio of the net present value of the new debt that is exchanged for the net present value of the existing debt. The last time I checked, some of the general obligation debt was trading at about 66 cents on the dollar, implying an expected recovery rate of 66% of the value of the existing bonds. That’s not awful. Unless you bought it at par.

Did anyone see this coming?

Hell, yes. Just to give a shout out to one asset manager (and I don’t invest with this company, know any of these people, or otherwise shill for anyone), go read the article  Puerto Rico and Beyond - An Analysis of the Municipal Debt of US Territories by David Ashley of Thornburg Asset Management in April 2014.

The entire article is exceptionally informative and well-researched. What follows is a single brief excerpt (emphasis added). I urge you to read the entire piece.

Territory Debt: Its Role in Thornburg Municipal Portfolios

Investing in U.S. territory debt can have its place in a well-diversified portfolio, especially one that is robustly structured to withstand the volatility and price performance of these bonds. Thornburg has not been a buyer of Puerto Rican debt for approximately 15 years. This includes all debt issued by the commonwealth or any of its many debt-issuing entities such as the Puerto Rico Electric Power Authority (PREPA) and COFINA. In our view, the pricing of the securities has not accurately reflected the risks associated with ownership. Such risks include pervasive budget deficits, pension underfunding, growing debt levels and an increasing reliance on market access to roll over previously issued debt.

With the brutal sell-off of Puerto Rican debt in June 2013, these risks have been more accurately reflected in market prices, but even at these levels, prices still remain outside our comfort level. Should prices continue to decline, we may revisit our investment thesis on Puerto Rican bonds.

Because of the enhanced yield they offer and because of our careful attentiveness to the risk/reward trade-off, we do have exposure to both Guam and Virgin Islands credits in our municipal funds. 

Later we discuss some of the high profile legal issues involved in Brexit- e.g. how to think about the options for Britain staying part of the EU single market via trade agreements and treaties – which roughly boils down to adopting the Norway model or the Switzerland model. From the stratosphere.