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PUERTO RICO UPDATE

Monday, Sep 18, 2017

Seema Balwada, CFA / September 18,2017

COMMONWEALTH-COFINA DISPUTE BEGINS

Commonwealth Claim Filed 9/08/17: Relies on Semantics and Ambiguity…

COFINA Response Filed 9/15/17: Relies on Law and Legal Precedent…The Court seeks mediation to produce a consensual resolution prior to the hearing scheduled for December 4 to 8. However, the parties can request a summary judgement from the Court by October 13, 2017.

Resolving the COMMONWEALTH-COFINA Dispute is the defining issue in the restructuring of Puerto Rico’s debt. The Federal Oversight Board approved a government petition for Title III bankruptcy in May 2017 for both the Com-monwealth of Puerto Rico and COFINA. Both parties are represented by the Obama appointed Federal Board in charge of Puerto Rico’s finances. In August 2017, the Federal Board appointed the Unsecured Creditors Committee as the Commonwealth Agent and Bettina Whyte, a well-respected restructuring specialist approved by COFINA bondholders, as the COFINA Agent to resolve the COMMONWEALTH-COFINA dispute. COFINA’s revenue is derived from a Sales and Use Tax, a general Sales and Use Tax levied and collected by the Commonwealth since 2006 on a wide range of goods and services. In Fiscal 2017, the Commonwealth collected over $2.5 billion of Sales and Use Tax a collection rate of under 65%, however, $170 million more than the prior year. A total of $724 million of the first collected taxes of the $2.5 billion collected were transferred to the COFINA bond trustee for bond payments. The remaining $1.8 billion went into the Puerto Rico General Fund. A powerful precedent has been established over the past 10 years as the flow of dedicated Sales Tax revenue historically has been transferred to COFINA bondholders. The Commonwealth’s complaint hinges on semantics and ambiguity surrounding the legal intent of the COFINA enabling legislation Act 91 enacted into law May 2006. Unsecured creditors refuse to accept that the COFINA enabling legislation is an existing law of the land. Challenging the constitutionality of the COFINA structure is a strategy being attempted by unsecured creditors to gain some nego-tiation leverage during the mediation period.

Commonwealth Claim: The Commonwealth Agent alleges that Sales and Use Tax revenues are the exclusive property of the Commonwealth. The Commonwealth Agent shows no respect for the law that enacted the COFINA statutory lien which gives COFINA bondholders a priority lien on COFINA Sales Tax revenues. The Commonwealth Agent views Sales and Use Tax revenues pledged to COFINA as either an unsecured promise or a grant of security interest not perfected under the Uniform Commercial Code. The Commonwealth Agent alleges that the COFINA structure is unconstitutional because COFINA enabling legislation violates the Puerto Rico Constitution’s General Obligation (GO) debt limits, payment priorities and the balanced budget clause. The Commonwealth Agent has no respect for the enabling law’s Constitutional Debt Priority Provision that makes the revenue dedicated to COFINA bondholders “unavailable resources” to the Commonwealth. An example of weak logic utilized by the Commonwealth Agent is obvious in its explanation why COFINA revenues belong to the Commonwealth: “Perhaps the most powerful demonstration that COFINA does not own future Sales and Use Tax revenues is that the Commonwealth has unilaterally reallocated such revenues to its General Fund.” The Commonwealth’s flawed action of unilaterally reallocating Sales Tax revenues to its General Fund is being challenged as Puer-to Rico law clearly states the dedicated revenue as “unavailable resources” to the Commonwealth. The reallocation of funds and the Agent’s logic disregard the fact the legislature passed a law that created the statutory lien. The Agent’s logic reveals a lack of any sound legal basis for its claim to the COFINA bondholders’ dedicated revenue. The Commonwealth Agent’s complaint relies on semantics to find fault in the enabling legislation, Act 91, that created COFINA. The Commonwealth Agent states ambiguity in the enabling Act stating, “the law has no comprehension of a present transfer of future property, therefore, future Sales and Use Tax revenues securing the COFINA bonds are not COFINA’s vested property.” The complaint basically states that Puerto Rico legislative assembly passed a law that only mandated a statutory transfer of funds to bondholders for the year the law was enacted not for future years. Even though the dedicated Sales Tax revenue has flowed to bondholders for over 10 years, the Commonwealth Agent wants a court declaration with respect to future funds. The Agent states the statutory lien transfer language in the enabling legislation Act 91 is ambiguous and at best an unsecured promise that Sales and Use Tax revenue would continue to be transferred to COFINA in the future. The complaint says the Commonwealth intends to breach, revoke or reject the promise between the Commonwealth and COFINA. The Commonwealth states there is no enforceable security agreement between COFINA and the Commonwealth. The Commonwealth Agent takes this position even though legal opinions from lawyers for COFINA as the bond issuer, lawyers for bond underwriters and the lawyers of the Commonwealth of Puerto Rico Department of Justice all state the bondholder’s statutory lien on the first collected Sales and Use Tax should be viewed as a Perfected Statutory Lien. The Commonwealth Agent expects the Court to disregard those legal opinions and void Sales and Use Tax transfers dating back to two years before the Commonwealth Title III petition. The Commonwealth Agent refutes the Commonwealth’s creation of the COFINA structure stating that “it cannot be the case, that to evade constitutional debt limits the Commonwealth can simply go “off-balance sheet” by diverting general tax revenues to a special purpose entity created for the sole purpose of issuing bonds to pay the Commonwealth’s own debt and expenses.” The Commonwealth wants a court declaration that Act 91 is unconstitutional because the CO-FINA structure evades constitutional debt limits and constitutional debt priorities set for “full faith and credit” Common-wealth GO debt as well as the balanced budget clause of the Puerto Rico Constitution. Again, the Commonwealth Agent ignores the Constitutional Debt Priority Provision afforded COFINA in the COFINA enabling law and the fact that in previous court briefs the Commonwealth stated the COFINA structure is legal. The Commonwealth Agent also does not mention COFINA was created at a time when investors lost confidence in Puerto Rico’s ability to control spending and manage their finances. In 2006 Puerto Rico GO bonds could not gain access to the market at reasonable interest rates. The ironclad provisions of the COFINA structure gave investors confidence to purchase COFINA bonds. Since the government could not touch the revenue dedicated to COFINA bondholders, COFINA had access to the market at very reasona-ble rates. Ever since NYC created a similar structure in the late 1970’s the COFINA type sales tax structure has been utilized by states and cities throughout the U.S. municipal bond market. In essence the Commonwealth complaint presented by their Agent basically states that the statutory lien and Puerto Rico law are illegal, therefore, COFINA revenue is the property of the Commonwealth and bondholders have no right to any of the revenue. 

COFINA Response: In a clear fact-based response the COFINA Agent detailed to the Court how the Common-wealth is trying to misappropriate billions of dollars that are the property of COFINA Bondholders. The Commonwealth’s shameless attempt to seize sales and use tax pledged by law to COFINA holders is inconsistent with the many repeated assurances made by the Commonwealth to COFINA bondholders and the U.S. municipal market.

The COFINA bond structure was enacted into law in 2007, as a tax backed securitization financing plan to pull the island out of a financial crisis. For ten years following the implementation of the COFINA bond structure, the Commonwealth and the legislative assembly repeatedly reaffirmed COFINA’s property rights. Three Secretaries of Justice serving three different administrations of alternating political parties have issued a total of six opinions confirming the validity of the transfer of pledged sales and use tax to COFINA, and that pledged Sales and Use Tax are “not available resources” of the Common-wealth.

Similar tax-backed securitizations are employed by states and municipalities throughout the United States. Tax-secured bonds are supported by segregated tax revenue pledged to an independent entity to issue bonds to be repaid through a predictable and dedicated revenue stream. This year the Commonwealth reneged on its decade long affirmation of the COFINA bond structure. The Common-wealth’s changed position is more than just a legal dispute. It calls into question moral hazards. It is a fraud perpetuated by vote mongering politicians. There was no reason for COFINA bondholders to suspect that the Commonwealth would not uphold its own laws or that it intentionally structured COFINA to deceive investors. The Commonwealth’s misappropriation violates the Constitutions of the United States and Puerto Rico. The Com-monwealth’s attempted confiscation of COFINA Pledged Security unreasonably impairs the obligation of contracts. The Commonwealth Agent is trying to mischaracterize Puerto Rico law which transfers the bondholders’ dedicated sales tax fund to COFINA and states expressly that those future funds “shall be the property of COFINA”. Dedicated rev-enue streams are the backbone of the $4 trillion muni market for securitization transactions, are commonplace in municipal finance and have been endorsed by the courts across the United States. Dedicated revenue streams are common bond structures that states and governments rely upon to raise capital. Upon the enactment of Law 56 of 2007, COFINA owned a dedicated stream of pledged Sales and Use Tax, including future collections. The COFINA Agent asks the Court to permanently restrict the Commonwealth from diverting pledged Sales and Use Tax away from COFINA bondholders and not interfere with COFINA’s rights and obligations under the COFINA bond resolution. The COFINA Agent wants the Court to declare that the all pledged Sales Tax transfers and future collections are “not available resources” of the Commonwealth and that COFINA has a perfected statutory lien on the stream of pledged Sales and Use Tax. The COFINA Agent wants the Court to declare that the Commonwealth’s attempted misappropriation violates the Constitutions of the United States, Puerto Rico and PROMESA Law enacted in 2016 for U.S. Territories. Put simply, the Commonwealth is attacking the COFINA structure in a short-sighted attempt to misappropriate COFINA’s property which by law secures COFINA bonds. If investors cannot trust the Commonwealth’s laws that provide bondholder security, the Commonwealth will be unable to access capital markets.

Puerto Rico Laws That Assured Payment to COFINA Bondholders

Act 91 of 2006 created COFINA and the dedicated revenue stream providing the dedicated revenues are “not available resources” under the Constitutional provisions relating to full faith and credit general obligation bonds.

Act 56 of 2007 states “The Dedicated Sales Tax Fund and all funds deposited on the effective date of this Act and all the future funds that must be deposited in the Dedicated Sales Tax Fund shall be the property of COFINA.” 

Act 56 of 2007 states “The Dedicated Sales Tax Fund shall be funded each fiscal year from the designated sources, the proceeds of which shall be directly deposited in the Dedicated Sales Tax Fund and shall not be deposited in the Treasury of Puerto Rico and shall not constitute “available resources” to the Commonwealth of Puerto Rico.

Legal Opinions with each COFINA bond issue came from reputable counsel to confirm the validity of the COFINA bond structure. (Opinion Letter of Hawkins Delafield & Wood LLP, June 2009; Pietrantoni Mendez & Alvarez LLC June 2009, December 2011; Nixon Peabody February 2010, December 2011.) 

Secretaries of the Puerto Rico Department of Justice serving three different Puerto Rico administrations of alternating political parties have issued a total of six legal opinions confirming the validity of the transfer of pledged Sales and Use Tax to COFINA, and that the dedicated revenues are “not available resources” of the Commonwealth.

Ratings by Moody’s reiterated that the agency relied on COFINA’s sole ownership over the Pledged Dedicated Sales Tax Funds to assign a high “AA3” rating to senior COFINA bonds, “A1” rating to subs. S&P emphasized that its high “AA-” rating for the senior COFINA bonds, “A+” for subs, reflected “a strong legal structure that separates the revenue stream supporting the COFINA bonds from the Commonwealth of Puerto Rico.”

Takings Clause of the Fifth Amendment to the United States Constitution provides that “private property (dedicated COFINA revenues) shall not be taken for public use, without just compensation.” The Takings Clause is applicable to the States and the Commonwealth.

Contracts Clause of the United States Constitution prohibits any State from “passing any law impairing the obligation of contracts.” The Contracts Clause also applies to Puerto Rico Constitution which provides that “no laws impairing the obligation of contracts shall be enacted.” The Contracts Clause makes it illegal not to pay COFINA bondholders.

PROMESA states any fiscal plan approved by the Oversight Board must “respect the relative lawful priorities or lawful liens, as may be applicable, in the constitution, other laws, or agreements of a covered territory.” 

Ironically 10 years after COFINA was created to rescue Puerto Rico during their 2006 financial crisis, COFINA bondholders find themselves in the ungrateful Commonwealth’s crosshairs. COFINA bondholders are faced with an in-conceivable narrative that cannot possibly be true… The Commonwealth of Puerto Rico’s claim is essentially stating Puerto Rico has deceived every COFINA bondholder and now looks to benefit from its deception.

Puerto Rico again finds itself in the midst of another financial crisis and will eventually need to raise capital to pro-mote growth and restructure its debt. COFINA or a similar structure will be critical to that effort. Once again investors will be unlikely to invest in new Puerto Rico debt unless the debt is secured by property beyond the reach of the Puerto Rico government and general creditors.

A major goal of PROMESA is for Puerto Rico to have access to the municipal bond market. The Court must realize the Commonwealth is shutting the door to market access by attempting to invade the COFINA structure, undermining investor confidence in the government and jeopardizing the Commonwealth’s chance of raising capital in the future.


If you have any questions or desire updated information contact your GMS Account Executive. Information taken from sources deemed reliable. This update does not purport to include all available information

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