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PUERTO RICO UPDATE

Wednesday, May 10, 2017

Seema Balwada, CFA / May10,2017

Based On Law And Legal Precedent Puerto Rico Bondholders Believe They Have A Strong Case In The Federal Court Supervised Bankruptcy-Like Proceedings That Dawned After The May 1 PROMESA Litigation Stay Ended. Viewed As A Positive Development By Creditors, Puerto Rico’s Debt Resolution Will Now Be Controlled By A U.S. District Court Judge. Bondholder’s Main Contention With The Oversight Board Is A Flawed Fiscal Plan. Legal And Statutory Creditor Protections Ignored By The Oversight Board Have Been Claimed In Lawsuits By Bond Insurers And Creditors Groups For Over A Year. For Bondholders, The First Order Of Business Is A Legal Fiscal Plan.

The resolution of Puerto Rico (PR) debt will now be controlled by a Federal Judge appointed by the U.S. Supreme Court, with input from the seven member Oversight Board appointed by the White House and creditors. On June 30, 2016 President Obama signed the Puerto Rico rescue law the “Puerto Rico Oversight, Management, and Economic Stability Act” (PROMESA). PROMESA provides a federally controlled debt restructuring framework for U.S. territories through mandatory good faith consensual debt adjustment negotiations ‘Title VI’. If Title VI fails to achieve results after good faith negotiations have taken place, the Board can request a bankruptcy-like U.S. District Court legal proceeding ‘Title III’. Bondholders allege good faith negotiations under Title VI have not taken place. Immediately after a stay on litigation provided by PROMESA ended, the Oversight Board filed a voluntary petition in San Juan’s U.S. District Court to restructure the Island’s constitutionally protected General Obligation (GO) and Commonwealth guaranteed debt under Title III of PROMESA. A Title III filing for Sales Tax secured debt issued by COFINA closely followed. Bondholder groups allege good faith consensual debt adjustment negotiations never occurred. U.S. District Judge Laura Taylor Swain of the Southern District of New York, a Manhattan Federal Judge will oversee PR’s Title III bankruptcy.

ORDERLY U.S. DISTRICT COURT CONTROL VIEWED OVERALL POSITIVE
Overall, Puerto Rico’s decision to invoke Title III under PROMESA marks a positive step for bondholders although a court proceeding will take some considerable time. Based on the Board Certified Fiscal Plan dated March 13, 2017 there will be some loss of principal for all PR bondholders. Moody’s noted on May 8, 2017, “Together with likely future filings related to affiliated government borrowers, this action should help establish an orderly framework to address competing creditor claims and those of pensioners, leading to higher overall bondholder recoveries, and, by extension, lower loss claims on insured exposures of the financial guarantors.”Fitch noted on May 5, “Although sales tax revenues pledged to COFINA continue to be set aside per the flow of funds and debt service has been paid, there is significant uncertainty as to the eventual impact of a broader restructuring of the Commonwealth’s debt on COFINA bondholder protections,” keeping its ratings on PR debt unchanged.

S&P noted on May 3, “For creditors, Title III could have the advantage of a potentially global solution that might arrive more quickly and with lower legal costs, but it also strengthens Puerto Rico’s protection against legal claims,” stating that principal recovery rates would have remained uncertain either within or outside Title III.A Title III filing does not preclude efforts for a voluntary consensual restructuring. Title III, a bankruptcy-like judicial process, created under a U.S. rescue law, places on hold several lawsuits against Puerto Rico, the Federal Oversight Board and its seven members. Fed Board Chair Carrion stated, “The Oversight Board continues to believe that consensual negotiations are preferable to the extent possible and will pursue them with all creditor groups willing to do so.” PR stopped paying GO debt service on July 1, 2016 following Governor Padilla’s alleged illegal executive order known as Moratorium Act. Trustee held reserves helped pay Highway Transportation Authority (HTA) debt service to date, prior to PR illegally clawing back transportation revenue for its General Fund. PR is current on all debt service payments on COFINA bonds and PREPA bonds.PROMESA seeks to honor legal pledges and bondholder covenants: Municipal obligations with stronger legal pledges will, all things being equal, provide better ultimate recovery rates in the event of default caused by extreme fiscal and liquidity pressures. Bondholders allege the Oversight Board has ignored legal pledges and bondholder covenants.

OVERSIGHT BOARD CERTIFIED PLAN LEGALLY FLAWED
The most important initial requirement PROMESA places on the Oversight Board is the creation of a long term Fiscal Plan that makes PR fiscally responsible and gives the Island access to capital markets. On March 13, the Oversight Board certified a Fiscal Plan allocating $7.9 billion aggregate debt service payments over ten years on $52 billion aggregate debt issued by 12 bond issuers without taking a position on bond indentures, covenants, liens or issuer. The Fiscal Plan elevates 94% of PR revenues to general expenses above bondholder legal rights granted by governing constitutional provisions and bond indentures. A major bondholder stated, “Far from restoring Puerto Rico’s access to capital markets, which is the primary objective of PROMESA, the Fiscal Plan seems designed to undermine it.” The Ad Hoc Group of General Obligation bondholders, Franklin Advisors, Oppemheimer Funds, Santander Funds and Assured Guaranty collectively asked the Oversight Board on March 27, 2017 to correct several flaws in the board certified Fiscal Plan noting “By providing the payment of Constitutional Debt only after all of the Commonwealth’s expenditures, the Fiscal Plan violates Puerto Rico’s Constitution and PROMESA Section 201(b)(1)(N).” The Fiscal Plan’s transfer of all COFINA revenues to the Island’s general funds violates PROMESA Section 201(b)(1)(N), Section 201(b)(1)(M) and COFINA Act 91. The Fiscal Plan also violates PROMESA Section 201(b)(1)(M) in its treatment of COFINA by transferring COFINA property to the Island’s General Fund. Similarly, violations were noted for HTA, Puerto Rico Convention Center District Authority and Puerto Rico Infrastructure Financing Authority debt as valid claw back revenues cannot be disposed of at the Commonwealth’s discretion.Despite differing views and holding varied bond structures, bondholders unanimously called out that diversion of bond collateral is illegal and that the Oversight Board’s approach of ignoring lawful liens and priorities by funneling all revenues into the General Fund for the payment of general expenses before debt service is inconsistent with PROMESA and the Puerto Rico Constitution. In answer to Senate Banking Cmte members concerns of the Board’s interpretation of PROMESA’s language and Congress’s legislative intent, the Oversight Board offered a feeble defense to Senate Banking Cmte members saying, “As you know, Congress deployed the word ‘respect’ while consciously twice declining to use ‘comply with’ ‘Respect’ provides flexibility and is different than the words Congress used for other Fiscal Plan requirements, such as to ‘ensure’ the funding of essential public services. In essence the Oversight Board’s position entirely ignores Section 201(b)(1)(N) which requires a certified Fiscal Plan to respect the relative lawful priorities or lawful liens, as may be applicable, in the constitution, other laws, or agreements of a covered territory” in essence the Board stated it has the ‘flexibility’ to ignore laws.The Oversight Board is squarely at odds with Congress’s stated intent. With bias towards Island politics, the Oversight Board has lost credibility and the respect of bondholders. At the outset, both the Oversight Board and Governor Rossello flaunted a bondholder friendly posture but allegedly delivered an unlawful Fiscal Plan. Reflecting confidence in legal creditor protections, PR bond prices gained when bond insurers rejected lowball offers that proposed recoveries between 52 to 77 cents on the dollar for unsecured constitutionally guaranteed General Obligation bonds, 39 to 58 cents for secured by dedicated revenue COFINA bonds premised on the flawed Fiscal Plan. Bondholders anticipate a more orderly resolution of PR debt from a Federal Court supervised judicial process. The Federal Court will have to assess the board certified Fiscal Plan and weigh competing claims on Puerto Rico’s resources. Politicians defend a bloated bureaucracy, pensioners assert promises made and bondholders stress relative strength of legal protections. The Island territory may start facing consequences for their actions in U.S. Federal Court, nearly two years after defaulting on debt service. The first court hearing is tentatively scheduled for Wednesday May 17.

U.S. SUPREME COURT RECOVERY LAW 2016 RULING BOOSTS BONDHOLDERS STRENGTHS
In 2015 Puerto Rico created its own municipal bankruptcy law called “The Recovery Act”. Validating creditors’ search for the rule of law, the U.S. Supreme Court ruled 5-2 in June 2016 and voiced a majority opinion that “barred Puerto Rico from enacting its own municipal bankruptcy scheme to restructure its debt.” The Supreme Court of the United States (SCOTUS) invalidated the Recovery Act which the Commonwealth enacted in 2014 and upheld the rulings of two lower courts in a case brought in 2014 by Franklin Templeton and Oppenheimer Rochester. The U.S. Constitution’s “Contract Clause” and “Takings Clause” provides that “private property shall not be taken for public use, without just compensation” supported by SCOTUS ruling on PR’s previous confiscation through its invalid Recovery Act are strengths for bondholders. Time and again, SCOTUS has ruled to honor existing Legislation and the Constitution.

BOND INSURERS & CREDITOR GROUPS ARE PROMINENT ADVOCATES
As arbiters of the Island’s future capital access, bond insurers and large creditor groups are leading negotiations with the Commonwealth and invoking legal remedies in court. Over the last year, numerous lawsuits have been filed by bondholders in the U.S. District Court of San Juan, where Judge Francisco Besosa is presiding. Bondholders are insisting PR respect its Constitution, the U.S. Constitution and original rescue law PROMESA. Bondholder suits were brought against Governor Padilla’s Moratorium Act which illegally transfers pledged revenue away from bondholders and asked for rights of contract, property and due process. Bondholders sought to lift PROMESA’s litigation stay. The Puerto Rico Government and the Oversight Board have paid little attention to bondholder allegations asserting illegal actions.

Bond Insurers… Assured Guaranty Corp., Ambac Financial Group Inc. and Financial Guaranty Insurance Co., claim that Puerto Rico violated the U.S. Constitution by depriving them of their property rights when Garcia Padilla illegally raided funds earmarked for debts and funneled the revenue into the General Fund. Assured sued the Highways and Transportation Authority for using toll money for expenses other than debt service. Hedge fund Peaje Investments LLC, a holder of highway debt, is pressing for the case to proceed. National Public Finance Guarantee Corp., which insures about $3.6 billion of Puerto Rico debt, filed suit over Puerto Rico’s debt moratorium law, saying it violates U.S. law and amounts to the seizure of personal property without sufficient compensation. Assured has insured approximately $5.4 billion of Puerto Rico’s public debt, National has insured about $3.6 billion of the Commonwealth and its public corporations’ indebtedness and AMBAC has insured $2 billion of PR debt including $187 million GO debt and $800 million COFINA bonds.

General Obligation and Commonwealth Guaranteed Bondholders… Hedge Funds Lex Claims, Jacana Holdings et al claim Puerto Rico violated PROMESA by diverting revenues and shifting money around ahead of its bond default. Hedge funds that purchased General Obligation bonds issued in 2014, the last time Puerto Rico issued such debt, also filed a separate case in Federal Court in Manhattan, claiming the Commonwealth can’t use its debt moratorium law to skip payments on those specific constitutionally guaranteed securities. That debt issuance, which came after PR rating was cut to junk, is the only one that gave creditors the option to sue in a court outside of Puerto Rico.

Government Development Bank Bondholders… Hedge funds Brigade Capital et al that own Government Development Bank (GDB) debt also challenge former Governor Padilla’s actions and are seeking to stop the bank from allocating cash to local agencies and foregoing loans, while another was filed by aggrieved Puerto Rican residents who own GDB bonds.

Employees Retirement System (ERS) Bondholders… Hedge fund Altair Global Credit Opportunities Fund sued the Puerto Rico employees’ retirement system seeking to have contributions to the system placed in an account for bondholders while the case is on hold. The court on April 20 ordered the retirement system to direct money every month to repaying interest on the pension fund bonds.

U.S. Bank, Bond Trustee… U.S. Bank Trust National Association sued the University of Puerto Rico for diverting and shifting funds.

GO COFINA Bondholders… Unsecured General Obligation bondholders are also seeking to stop Puerto Rico from prioritizing its dedicated revenue secured Sales Tax backed bonds which to date have been paid in full. Puerto Rico's Constitution gives the GO bonds a first lien on the government's available resources, but the GO debt has no specific dedicated revenue or security interest. COFINA bonds, which have a dedicated sales tax revenue stream, also have a strong security structure as COFINA bonds were issued with legal opinions stating that pledged sales tax revenues were not “available resources” to the Commonwealth and not subject to the Puerto Rico Constitution's “clawback” mechanism that ensure GO debt repayment. The COFINA debt was designated to have near ironclad protections. Judge Besosa, who was the first to rule PR’s Recovery Act as unconstitutional, has consolidated some lawsuits. Unified and forceful, bondholders appeal that rule of law should prevail strong legal arguments voiced in the lawsuits should be adjudicated by Judge Laura Taylor Swain.

BOND INSURERS ASK FOR A LEGAL FISCAL PLAN
The end of a PROMESA litigation stay saw another flurry of lawsuits from bond insurers and creditors. Holders of $16 billion COFINA sales tax secured bonds were the first to challenge the Fiscal Plan accusing Puerto Rico officials of strong-arming bondholders into what it called ‘unfair, unjust and illegally punitive terms’. The board certified fiscal plan should not be used as a basis for any lawful plan of debt adjustment, stated bond insurers Assured Guaranty and National Public Finance Guaranty filing adversary complaints stating “The Commonwealth’s Fiscal Plan, dated March 13, 2017 as implemented through the newly enacted Fiscal Plan Compliance Law totally disregards constitutional priorities and liens and therefore constitutes a gross violation of the clear statutory mandates of PROMESA.” This complaint comes on the heels of similar actions by AMBAC who also asked to prohibit a Title III filing premised on a flawed Fiscal Plan.The alleged illegal Fiscal Plan overturns generations of Federal Constitutional law governing the priority and protection of secured debt by giving all general expenses and all unsecured debts payment priority over the payment of any bond debts granted constitutional first priority or secured by liens. Creditors are asserting a legal Fiscal Plan must “ensure that assets, funds, or resources of a territorial instrumentality are not transferred” for general use, in accordance with federal law PROMESA.The legality of the board certified Fiscal Plan becomes the immediate issue in the hands of the Federal Courts.

ITEMS OF INTEREST TO BONDHOLDERS
• Tentative hearing before Judge Swain scheduled for May 17
• Judge will ascertain whether obligations to engage creditors in good faith and other preconditions have been satisfied
• Judge Swain will be the one who evaluates the Board’s Certified Fiscal Plan
• Consensus - the restructuring process could take 18 to 36 months
• The Federal Government is not expected to provide any direct federal aid other than technical assistance. There is the possibility of increased Medicaid assistance in an amount closer to what comparable size states currently receive
• Judge Swain will eventually determine if recovery values offered by the Board are fair to creditors considering priority liens and Puerto Rico’s operational needs
• Whether any bonds including dedicated revenue secured COFINA will pay interest during the process will be determined by Judge Swain

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. PROMESA seeks to honor the legal hierarchy of Puerto Rico’s debt structure.

PROMESA was enacted into law under Article 4 of the U.S. Constitution specifically for distressed U.S. territories to provide a federal controlled debt restructuring framework for U.S. territories.
PROMESA creates a fiscal control board or Oversight Board that has control over Puerto Rico's budget and financial plans.
PROMESA has laid out two debt restructuring mechanisms: Title VI: Voluntary consensual debt adjustment and Title III: Bankruptcy-like U.S. District Court legal proceedings. A PROMESA restructuring process would follow principles of the US Bankruptcy Code, which are incorporated in the law, although the proceeding would not occur in bankruptcy court.

PROMESA Section 201(b) (1) requires the Oversight Board to certify a fiscal plan that “provides a method to achieve fiscal responsibility and access to the capital markets.”

PROMESA Section 201(b)(1)(N) asks the Oversight Board to ensure that any proposed debt restructuring is consistent with a fiscal plan that honors “the relative lawful priorities or lawful liens, as may be applicable, in the constitution, other laws or agreements of a covered territory or covered territorial instrumentality.”

PROMESA Section 201(b)(1)M) asks the Oversight Board to ensure that assets or funds of a territorial instrumentality are not loaned to, transferred to other otherwise used for the benefit of a covered territory or another covered territorial instrumentality unless provided by the constitution or approved under Title III or Title VI.

PROMESA Section 314(b)(6) requires that the court find that the debt restructuring plan is both feasible and “in the best interests of creditors which shall require the court to consider whether available remedies under the non-bankruptcy laws and constitution of the territory would result in a greater recovery for the creditors..”

PROMESA Section 407, Protection of Creditors states, “While an Oversight Board for Puerto Rico is in existence, if any property of any territorial instrumentality of Puerto Rico is transferred in violation of applicable law under which any creditor has a valid pledge of, security interest in, or lien on such property, or which deprives any such territorial instrumentality of property in violation of applicable law assuring the transfer of such property to such territorial instrumentality for the benefit of its creditors, then the transferee shall be liable for the value of such property.”

Puerto Rico Constitution Art. VI, Sec. 8 Sec. 2 provides that when available resources are insufficient to cover all of the Commonwealth’s obligations, Constitutional Debt shall be paid first. Certain pledged revenues such as gasoline, petroleum, cigarettes, rum and hotel room taxes are subject to being applied first for payment of public debt service if needed or ‘clawed back’ for constitutional debt service. Puerto Rico's constitution also states that bondholders may bring suit to require application of budgetary surplus or other available resources to pay debt service. Under the commonwealth's statute, the payment of GO and guaranteed debt has the highest priority for disbursement of public funds. It is followed in order by contractual obligations; legal judgments or other similar obligations; and core governmental expenditures including health, education, and retirement funding.

COFINA Act. 91 of May 13, 2006 created The Puerto Rico Sales Tax Financing Corporation (by its Spanish acronym, COFINA) is an independent instrumentality of the Commonwealth of Puerto Rico for the specific purpose of financing the payment, retirement or defeasance of certain debt obligations of the Commonwealth of Puerto Rico outstanding as of June 30, 2006, which were payable to the GDB and the Puerto Rico Public Finance Corporation (PFC) and were previously payable solely from government budgetary appropriation. COFINA's enabling statute created a dedicated sales tax fund held and owned by the corporation, separate from the commonwealth's general fund, to receive legally allocated revenues. In connection with COFINA issuances that began in 2006, Puerto Rico represented that COFINA's revenue stream was insulated against the constitutional provisions that can allow revenues to be redirected to GO bondholders, under the claw back mechanism. “The Dedicated Sales Tax Fund, the funds on deposit therein and the Dedicated Sales Tax do not constitute available resources of the Commonwealth” for the purposes of the claw back mechanism, Puerto Rico's Secretary of Justice wrote in a 2009 opinion.

Puerto Rico’s Management and Budget Office Organic Act, 23 L.P/R/A 104(C ) recognizes the constitutional requirement that Constitutional Debt shall come first, and specifies that payments on certain contracts, public health, safety and others shall only be made after Constitutional Debt payment.

[Executive Order OE-2015-046 issued by Governor Padilla on December 1, 2015 instructing the retention of revenues assigned to PRHTA, PRIFA, the Metropolitan Bus Authority (AMA), the Integrated Transport Authority (ITA) and the Puerto Rico Convention Center District Authority. ‘Claw Back’ revenues are illegally held at Banco Popular instead of paying G.O. bond debt service. In January 2016, Governor Rossello touted that funds would be released to G.O. bondholders but that did not happen.]

Commonwealth of Puerto Rico Et Al. v. Franklin California Tax-Free Trust Et Al Case law 2014 landmark 5-2 ruling , in which the U.S. Supreme Court held that Federal law preempts Puerto Rico from enacting its own bankruptcy laws and invalidated the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the Recovery Act), which the Commonwealth enacted in 2014.

“PROMESA will be positive for holders of Puerto Rico's bonds because it provides an orderly framework to restructure the territory's debt, stabilize its economy and improve its financial management practices.”
Moodys August 2016

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