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Muni Week Review / Preview 3/28/2017

Tuesday, Mar 28, 2017


March 28, 2017

Dear Members of the Oversight Board:This letter is being sent by the following holders and insurers of bonds issued by the Commonwealth of Puerto Rico or its territorial instrumentalities (collectively, the "Government of Puerto Rico"): The Ad Hoc Group of Puerto Rico General Obligation Bondholders (the "GO Group"), which holds  approximately $3 billion of bonds issued or guaranteed by the Commonwealth of Puerto Rico. Certain funds managed by Franklin Advisers Inc., certain funds managed by Oppenheimer Funds, Inc., and certain funds managed by Santander Asset Management, LLC (the "Major COFINA Bondholders"),which hold approximately $3.65 billion of bonds issued by COFINA and approximately $1.85 billion of bonds issued or guaranteed by the Commonwealth of Puerto Rico. Assured Guaranty Corp. and Assured Guaranty Municipal Corp.("Assured") as insurer of approximately $1.75 billion of bonds issued or guaranteed by the Commonwealth of Puerto Rico, and approximately$1,675 billion of secured revenue bonds issued by HTA,PRCCDA, and PRIFA (collectively, the "Petitioning Creditors"): On March 13, 2017, you certified the Fiscal Plan for Puerto Rico (the "Fiscal Plan"). We write for the purpose of calling upon you to provide certain additional information concerning the Fiscal Plan and to address certain deficiencies pertaining thereto. Although the Petitioning Creditors' interests are diverse,we share an interest in expeditiously resolving the Government of Puerto Rico's financial crisis. As the Fiscal Plan states, it is "intended to represent the basis upon which the Government and its creditor constituencies can, for the first time, conduct real and meaningful dialogue." (Fiscal Plan at 5.) If the Fiscal Plan is to serve as the basis for dialogue, it must persuade creditors, not dictate to them and creditors must fully understand the assumptions, analyses and rationales underlying the Fiscal Plan, so that the Government of Puerto Rico can reach an agreement with creditors and regain its desperately needed credibility with the capital markets.Respectfully, we believe that the Fiscal Plan violates many of the requirements of PROMESA. The Fiscal Plan also contains many unexplained numbers and assumptions that creditors need to understand before meaningful negotiations can occur. These include, but are not limited to:$6.2 billion "Reconciliation Adjustment" in non-budgeted expenses, over a ten-year period; $1.8 billion increase in payroll expenses, over a ten-year period, compared to maintaining a 2017 run rate level; $500 million increase in operational expenses, over a ten-year period, compared to maintaining a 2017run rate level; $9.3 billion in deficits at component units and other non-General Fund entities, over a ten-year period, with an annual growth rate of 10%; Tax collection rates and related assumptions embodied in the Fiscal Plan; Macro-economic assumptions, including components of GNP, the fiscal multiplier behind the projection for revenues and expenses, and the models behind the Fiscal Plan; and Any sensitivity analyses measuring the impact of recommendations from the Congressional Task Force on Economic Growth in Puerto Rico.The Petitioning Creditors have separately made prior attempts to engage you on these very topics. Unfortunately, we cannot see any reflection of our prior submissions. What's more, far from restoring the Government of Puerto Rico's access to the capital markets” the first and last goal of PROMESA”the Fiscal Plan seems designed to undermine it. We urge you to engage with us constructively and immediately on the topics that follow. The future of Puerto Rico depends on it. Accordingly, we highlight herein some of the key aspects of the Fiscal Plan that we believe require further consideration or potential amendment.

Failure to Respect Lawful Priorities and Liens: The Fiscal Plan simply ignores one of the enumerated requirements that Congress imposed on any fiscal plan, namely, that it "respect 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 in effect prior to the date of enactment of this Act." (PROMESA 201(b)(l)(N).) Congress authorized the Oversight Board to certify a fiscal plan that "satisfies such requirements." {Id. Â201(c)(3) (emphasis added).) If a fiscal plan "does not satisfy such requirements" then the "Board shall provide to the Governor a notice of violation." {Id. (emphasis added).) Here, the Commonwealth acknowledged that the Fiscal Plan did not comply with Section 201(b)(l)(N), and the Oversight Board stated that it did not have enough information to determine the Fiscal Plan's compliance with Sections 201(b)(1) (N). Instead of requiring correction, the Oversight Boardcertified the Fiscal Plan.  

The Constitutional Debt: Puerto Rico's Constitution expressly referenced in Section 201(b)(l)(N) clearly provides that, when available resources are insufficient to cover all of the Commonwealth's obligations, Constitutional Debt shall be paid first. (P.R. Const. Art. VI, Sec. 8.) Moreover, Puerto Rico's Management and Budget Office Organic Act, 23 L.P.R.A. 104(c), recognizes the constitutional requirement that payment on Constitutional Debt shall come first, and specifies that payments or disbursements related to certain contracts, public health, safety, education, welfare, pensions, and capital works and improvements shall only be made after payments on Constitutional Debt. By providing that payment on Constitutional Debt comes after all of the Commonwealth's expenditures, the Fiscal Plan violates Puerto Rico's Constitution and Section 201(b)(l)(N). We call upon you to correct this error or to explain why you believe this is not an error.

The Major COFINA Bondholders' and Assured's Positions: The Major COFINA Bondholders and Assured assert that the Fiscal Plan also violates Sections 201(b)(l)(M) and 201(b)(l)(N) in its treatment of COFINA, HTA, PRCCDA, and PRIFA.The Major COFINA Bondholders maintain that the COFINA structure is valid and therefore the Fiscal Plan violates Section 201(b)(l)(M) by transferring COFINA's property to the Commonwealth's General Fund and violates Section 201(b)(l)(N) by failing to respect the COFINA bondholders' lien on the assigned revenues granted to COFINA.Similarly, Assured has brought litigation challenging the Commonwealth's diversion of collateral that secures bonds issued by HTA, PRCCDA and PRIFA (each, an "Authority"). Assured and other Authority bondholders contend that the diversion of collateral securing bonds issued by the Authorities is illegal and therefore the Fiscal Plan violates Sections 201(b)(l)(M) and (N) by transferring such revenues to the Commonwealth and failing to respect the lawful liens and priorities relating thereto.The Oversight Board has repeatedly stated that it takes no position on these disputes, but such indecision does not constitute compliance with Congress' requirements under PROMESA. The Fiscal Plan takes all revenues and uses them for the payment of general expenses, without any regard to lawful priorities or liens. Regardless of how the above disputes may be resolved, that approach is plainly inconsistent with sections 201(b)(l)(M) or (N) of PROMESA.

Identification of Essential Services: The Fiscal Plan does not attempt to differentiate between expenses for essential services and expenses for non-essential services. While the Fiscal Plan lists this issue as one of the "legal and contractual issues not determined by the Fiscal Plan," it is also a key economic issue. (Fiscal Plan at 6.)  As certified, the Fiscal Plan presumes that all non-debt expenses are paid before any payments are made on debt service, yet the Oversight Board and the Government of Puerto Rico have never explained the legal or commercial basis for such a waterfall in the Fiscal Plan. We therefore ask you to address the following questions:  1.) What is the legal basis for that waterfall? 2.) Does this basis depend, in your view, on whether the expenses are for essential services? 3.) If the answer to question 2 above is yes, what portion of the projected annual expenses are for essential services and what are those services? If the Fiscal Plan does not distinguish between essential and non-essential services, how can it meet the requirements of PROMESA?It is not plausible that 100% of the approximately $18 billion in average annual expenses projected under the Fiscal Plan are for essential services. The persistent refusal of the Oversight Board and the Government of Puerto Rico to address this obvious question is telling.

Reconciliation Adjustment: As certified, the Fiscal Plan includes an incremental $6.2 billion "Reconciliation Adjustment" based upon the assumption that the Government of Puerto Rico will not adhere to its budget, which will be approved by the Oversight Board. Moreover, and notwithstanding the reforms proposed by the Oversight Board and the Government of Puerto Rico, the Fiscal Plan actually projects that this cushion will grow steadily over the next decade. (Fiscal Plan at 14 (noting "steady increase until 2026.").)In other words, the Fiscal Plan asks creditors”in addition to subordinating themselves to all government expenses, whether essential or note to further assume that the Government of Puerto Rico will need anannual "cushion" of approximately $600 million to pay for non-budgeted expenses. To reach such an expense level, the Government of Puerto Rico must not only miss this fiscal year's cost reduction targets, but alsoreverse last year's expense reductions and then grow expenses from fiscal year 2015 levels. Creditors are asked to make this assumption despite the Government of Puerto Rico's recent efforts to implement zero-based budgeting for each department. Incorporating this significant contingency reserve is contrary to the express language of PROMESA. First, Section 202 requires that the Oversight Board, the Governor, and the Legislature develop annual budgets for certain covered entities through an iterative process. To be approved, such budgets must be "compliant budgets," i.e., consistent with the Fiscal Plan. (PROMESA 202(e).) One of the key requirements for any fiscal plan is to eliminate "structural deficits," which is contrary to the very  inclusion of a Reconciliation Adjustment. (PROMESA 201(b)(1)(D).) Second, Section 203 requires the Government of Puerto Rico to submit quarterly reports to the Oversight Board detailing whether the Government of Puerto Rico is in compliance with its approved budget. In the event that the Government of Puerto Rico is not in compliance with its approved budget, the Oversight Board shall "make appropriate reductions in nondebt expenditures to ensure that the actual quarterly revenues and expenditures for the territorial government are in compliance with the applicable certified Territory Budget." (PROMESA 203(d)(1) (emphasis added).) The Fiscal Plan ignores these requirements and instead permits (i) structural deficits to persist into perpetuity, and (ii) the Government of Puerto Rico to build in a significant cushion upfront (a reserve nearly equal to the annual amount dedicated to debt service), and thereby reduce funds available for debt service. Congress clearly stated that structural deficits were to be eliminated and that if interim revenue/expense gaps arose, budgetary adjustments should be made from "nondebt expenditures." The net result of affording a $6.2 billion budgetary cushion would appear to defeat one of PROMESA's primary goals, i.e., fiscal discipline. Further, the assertion that the contingency reserve and non-essential services should lawfully come before all debt service creates an environment that requires an examination of limits arising under the United States and Commonwealth constitutions and will certainly impact the broader municipal bond market.

Other Expense Assumptions:The Fiscal Plan contains billions of dollars in other expenses that require further detail for the Petitioning Creditors to understand. In contrast to the February 28 Fiscal Plan, the Fiscal Plan that the Oversight Board certified increased payroll expenses by more than $1.5 billion and increased operational expenses by more than $400 million over a ten-year period. Neither the Oversight Board nor the Government of Puerto Rico has explained why the growth rate for expenses increased so significantly between February 28 and March 13' . Instead of instilling the necessary discipline to maintain fiscal year 2017 run rate expense levels, the Fiscal Plan allows payroll expenses and operational expenses to grow, which increases expenses by over $2.3 billion over a ten-year period. The Petitioning Creditors are entitled to understand the analysis that led to revising these amounts. The Fiscal Plan also includes expenditures that are not related to the General Fund or services provided by the central government of Puerto Rico. In particular, the Fiscal Plan includes $7.4 billion over a ten-year period in component unit expenses including ASEM, ASES, ADEA, PRIDCO, PRITA, Tourism, and UPR deficits. (Fiscal Plan at 14.) In all, deficits at component units and other non-General Fund entities have likewise increased” without explanation—by $715 million compared to the February 28th Fiscal Plan over a ten-year period. Moreover, the Fiscal Plan assumes a compound annual growth rate of approximately 10% for such expenses. This rampant expense growth leads to a $3.2 billion incremental deficit at these component units and non-General Fund entities, above the fiscal year 2017 run rate levels.To facilitate meaningful negotiations of a potential restructuring, the Petitioning Creditors must understand why the Government of Puerto Rico is forecasting $9.3 billion in expenses over a ten-year period to component units and other non-General Fund entities, and why those expenses, together with the General Fund's payroll and operating expenses, increased by more than $2.6 billion over a ten-year period compared to the February 28th Fiscal Plan.

Macro Economic Assumptions:The Fiscal Plan is built on a number of key macro-economic assumptions that are not sufficiently explained. In particular, the Fiscal Plan fails to disclose the components of GNP and the fiscal multiplier that drive the revenue and expense projections.The Petitioning Creditors need access to this critical information, includingaccess to the underlying models on which the Fiscal Plan is built, to perform necessary diligence on the Fiscal Plan. This would enable the Petitioning Creditors to better understand, for example, why certain expenses appear to grow at a higher rate than revenues and overall inflation, and why the Government of Puerto Rico's proposed structural reforms are not projected to have a more significant positive effect on GNP. Full access to these models and assumptions is critical to advancing negotiations.

Privatization:The Fiscal Plan fails to take into account any potential privatization of government assets, or the reductions in expenses that would accompany such privatization. On December 20, 2016, the Oversight Board stated that "[by privatizing a number of government assets, such as real estate, the state insurance fund and ports, forexample, Puerto Rico could fund near-term initiatives on a one-time basis, and potentially achieve better service levels at a lower cost. Government assets should be monetized with the specific aim of funding one-time investments in infrastructure development, like upgrading to broadband internet connections, and not funding continuous operations." Similarly, when seeking proposals from advisors, the Government of Puerto Rico has twice sought an advisor with expertise in "asset valuations, sales and privatizations." Despite the Oversight Board's and the Government of Puerto Rico's recent interest in such measures, the Fiscal Plan ignores the possibility of privatizing government assets and the attendant fiscal benefits. If executed effectively, privatization should produce measurable economic benefits through one-time cash infusions, a reduction in public capital funding requirements, and significant decreases in operational expenditures”none of which appear in the Fiscal Plan.

Tax Collection Rates: The Fiscal Plan fails to account for potentially significant additional revenues generated from improved tax collection and compliance reforms. It is widely understood that the Government of Puerto Rico's historical collection rates are low (for example, collection of sales and use tax ("SUT") was estimated to be no more than 67.9% in fiscal year 2016). During his recent State of the Commonwealth Address, Governor Rossello Nevares stated that improved tax collection would be a focus of his administration and would significantly increase the Government of Puerto Rico's revenues. However, the Fiscal Plan contemplates only modest improvements in tax collection rates. Given the impact that improved tax collection rates would have on the Government of Puerto Rico's revenues, we expect that the Oversight Board is supportive of these proposed compliance reforms. For example, based on 2016 SUT collections, each 1% improvement in collection rates represents an incremental $35 million in revenues. The Department of Hacienda under the prior administration projected a sustained 12%-17% improvement in SUT collections over the coming ten years, representing an incremental $420 million to $595 million annually on SUT revenues alone. Accordingly, the Oversight Board should provide the Petitioning Creditors with the collection rates that are implied in the Fiscal Plan and allow the Petitioning Creditors to test such assumptions in light of the Government of Puerto Rico's proposed reforms. Understanding the Oversight Board's assumptions regarding collection rates is also critical in light of recent data demonstrating that the Government of Puerto Rico is surpassing prior estimates. In particular, through February of fiscal year 2017, General Fund net revenues are approximately 3.5% higher than initially forecast, representing a $184 million increase over projections ($5.41 billion vs. $5.22 billion). Similarly,through February 28, 2017, Government of Puerto Rico revenues are approximately 1.7%higher than revenues over the same period in 2016, and revenues for fiscal year 2016 were 2.4% higher than revenues in fiscal year 2015.15 Given these recent trends, the Petitioning Creditors should understand why the Oversight Board adopted more pessimistic assumptions than initially proposed by the Government of Puerto Rico.

Federal Health Care Funds: As set forth in the February 28 Fiscal Plan, the expiration or continuation of funding under the Affordable Care Act has a significant effect on the Government of Puerto Rico's revenues and expenses. Although the outcome is undetermined at this time, it seems likely that Congress may act before December 31, 2017. It is difficult to assess the Fiscal Plan without considering the significant effect that federal health care funding has on the Government of Puerto Rico's budget and longterm fiscal outlook. To avoid informational asymmetries or other strategic impediments, we believe that the Oversight Board, acting together with the Government of Puerto Rico and the Congressional Task Force on Economic Growth in Puerto Rico (the "Task Force"), should immediately seek assistance from Congress (and other applicable agencies and departments) to restore federal health care funding and bring certainty to the Government of Puerto Rico.The future of federal health care funding is critical to the Government of Puerto Rico because of the spillover effect that it may have on population migration and therefore virtually every aspect of the Fiscal Plan. The Task Force announced its federal health care recommendations on December 20, 2016. Implementing the Task Force's recommendation should be an immediate concern of the Oversight Board, and cannot wait until after creditor negotiations.

Task Force Report:The Fiscal Plan does not incorporate the numerous recommendations contained in the Task Force's December 20, 2016 Report to the House and Senate (the "Task Force Report"). Many of the Task Force's recommendations address economic development initiatives and ways in which the Government of Puerto Rico can better utilize federal resources. At a minimum, creditors should have access to any sensitivities analyses measuring the impact of the Task Force's recommendations so they can understand the determination not to include those recommendations.

Access to the Capital Markets: Congress said that the purpose of any fiscal plan is to provide Puerto Rico "a method to achieve fiscal responsibility and access to the capital markets." (PROMESA) 201(b)(1).) Indeed, the Government of Puerto Rico's ability to access the capital markets goes hand-in-hand with its ability to implement pro-growt measures, and therefore successfully implement the Fiscal Plan.Unfortunately, the Fiscal Plan undermines investor confidence in Puerto Rico's commitment to paying debts, making Puerto Rico unlikely to be able to regain access to the credit markets at reasonable interestrates. After the Oversight Board certified the Fiscal Plan, trading prices of the Government of Puerto Rico's bonds fell. This indicates that investors have reduced confidence in the Commonwealth's and Oversight Board's willingness to pursue consensual settlements as favored by PROMESA and portends protracted and expensive litigation that will inhibit the Government of Puerto Rico's access to capital sorely needed to spark economic recovery on the island. Moreover, the Oversight Board's assumptions in the Fiscal Plan regarding, among other things, required amortization of principal in the debt sustainability analysis are inconsistent with the assumption that the Government of Puerto Rico regains capital market access. The inability to access capital markets will only exacerbate the Government of Puerto Rico's fiscal crisis by preventing it from refinancing its indebtedness at lower interest rates at Maturity.

Treatment of Clawback Revenues: The Government of Puerto Rico and the Oversight Board also suggest that the Fiscal Plan does not determine "the scope, timing, or specific use of revenues to be frozen or redirected as 'claw back' revenue." (Fiscal Plan at 6.) In fact, the Fiscal Plan does determine, in clear violation of PROMESA, the use of some claw back revenues that are assumed to be clawed back. While the Petitioning Creditors may have differing views as to the nature of their rights regarding these funds,16 they are unanimous in agreeing that the Fiscal Plan improperly assumes that revenues generated by a valid claw back may be disposed of at the Commonwealth's discretion. There is no basis upon which to explain the Fiscal Plan's treatment of these funds, other than a complete disregard for the rule of law. In no sense does the Fiscal Plan show the respect for lawful liens and priorities as required by PROMESA with respect to these monies.The enabling statutes, authorizing resolutions, and offering circulars for each of the claw back bonds expressly provide that the pledged revenues, which include taxes on gasoline, petroleum, cigarettes, rum, and hotel rooms, and vehicle license and registration fees, may only be clawed back (upon satisfaction of certain conditions) to pay Constitutional Debt, and not for any other purpose. Former Governor Garcia Padilla acknowledged this in Administrative Bulletin No. OE-2015-046, which stated that any funds clawed back and "retained by the Department of Treasury shall be held in a segregated account and shall only be used'' for the payment of Constitutional Debt. The current administration recognized the same thing when it recently announced that it would segregate claw back revenues in a trust for the payment of "constitutionally guaranteed general obligation bonds.The Fiscal Plan, however, assumes that the revenues may be clawed back (without discussing the stated conditions therefore), but does not segregate claw back revenues for the payment of Constitutional Debt. Instead, the Fiscal Plan allows such revenues to apparently be used for any and all purposes at the Commonwealth's discretion. For example, the Government of Puerto Rico has identified $978 million of claw back and other pledged funds in fiscal year 2017 alone, but the Fiscal Plan does not segregate these revenues for the payment of Constitutional Debt. Even more, the Fiscal Plan provides only $404 million and $567 million in total debt service for fiscal years 2018 and 2019, respectively, thereby guaranteeing that the Government of Puerto Rico”with the Oversight Board's blessing”will in fact use claw back revenues for purposes other than debt service on Constitutional Debt.Because the Fiscal Plan ignores that, assuming claw back revenues are appropriately clawed back, such revenues should be used to pay Constitutional Debt, it violates PROMESA Section 201(b)(l)(A)(i), which requires that all revenue projections be "based on applicable laws.The Petitioning Creditors respectfully request the opportunity to immediately discuss these specific issues with the Oversight Board and the Government of Puerto Rico in a constructive and cooperative manner. We believe that these discussions will significantly help advance negotiations and our shared goal of reaching anexpeditious and consensual resolution under Title VI of PROMESA.

Information obtained from sources deemed reliable; GMS does not purport Review/Preview contains all available information.