By James E. Spiotto

Puerto Rico flag

The Treaty of Paris ending the Spanish-American War of 1898 resulted in control of Cuba, Puerto Rico, Guam and The Philippine Islands being given to the United States.  Cuba in 1902 and The Philippines in 1946 were given independence.  Puerto Rico and Guam remain territories of the United State.  In recent years, Puerto Rico as a Commonwealth flirted with independence or statehood with no clear decision.

In 1996, Congress repealed (effective 2006) Section 936 of the Internal Revenue Code (previously Section 931) that existed since the 1920’s to encourage U.S. corporations to invest in Puerto Rico by providing an exemption from federal taxes.  This measure promoted two-thirds of Puerto Rico’s GDP, namely, in finance, insurance, real estate (19.6%), and manufacturing mainly in pharmaceuticals and electronics (46.4%).

By 2006, Puerto Rico was in financial distress due to at least in part to the effect of the Jones Act that purportedly added 10-15% to the costs of many goods due to the duty on non-U.S. ships, combined with repeal of Section 936 of the Internal Revenue Code without any replacement, as well as, Puerto Rico’s claimed inequity of federal government funding compared to states costing Puerto Rico billions annually for decades relating to Medicaid, Medicare, Supplemental Security Income (“SSI”), earned income tax credit (“EITC”), child tax credit (“CTC”), etc.  All of this culminated in finance distress.  In 2006, Puerto Rico had $40 billion of public debt and public debt per capita of $10,666.66, double the average for state and local governments in the U.S.  Also in 2006, Puerto Rico’s public debt as a percentage of GDP was 45.82%.

Historians may well debate the causes and impact of Puerto Rico’s financial and operational distress, but it should be clear public debt was not the cause of financial distress of the government.  It is a symptom of a systemic problem.  As noted, the Merchant Marine Act of 1920 adding 10-15% to the price of many goods carried by foreign vessels, the repeal of Section 936 of the IRS Code (previously Section 931) encouraged U.S. corporation to invest in Puerto Rico and Puerto Rico’s claimed inequities in its funding and treatment compare to states purportedly costing Puerto Rico billions annually for decades are a fertile ground for blame.

Puerto Rico was founded on the principles that public debt has a first priority of payment upon default (along with expense of insular government) embodied in Section 34 of the 1917 Jones Act, which governed Puerto Rico prior the Commonwealth’s Constitution in 1952.  The inclusion of Article VI, § 8 in the 1952 Puerto Rico Constitution continued this policy providing constitutional public debt, upon insufficient funds to pay expenses, were first to receive payment from “available resources.”  When faced with the 2006 financial crisis, Puerto Rico, with $40 billion of public debt outstanding, chose to borrow more rather than restructure its debt.  Puerto Rico used the COFINA securitization structure to add another $17 billion of public debt by 2015 that purportedly was not limited by the constitutional debt limit, resulting in public debt of Puerto Rico totaling over $72 billion.

Put another way, by 2006, Puerto Rico with $40 billion in public debt choose to literally double down on debt rather than face the then need for financial restructuring or federal government assistance such as oversight and refinancing of debt in 2006 rather than 2016 the ultimate result.  Between 2006 and 2015, $40 billion of public debt became $72 billion, the percent of debt to GDP rose from 45.82% to 69.83%, and per capita public debt more than doubled from $10,666.66 to $20,727.38 (the average for state and local government debt in the U.S.A. in 2015 was $5,633.88, one quarter of Puerto Rico’s).

Generally, the Puerto Rico public debt structure has followed the traditional structure used by U.S. states and local governments.  Puerto Rico’s over $13 billion of General Obligation Bonds follow the constitutional priority for payment of G.O. bond debt found in the constitutions and statutes of U.S. states like New York.  The financial distress case of New York City in 1975 demonstrates the effectiveness of this constitutional provision that was found to be binding and enforceable to end the moratorium on payment of bond debt that motivated a restructuring rather than a Chapter 9 bankruptcy for New York City as the Flushing National Bank case 40 N.Y.2d 731 (1976) described.  Further, the COFINA securitization structure is intended to be similar to New York City’s Sales Tax Receivable Corporation and not included in constitutional debt limits or offensive to the rights of outstanding G.O. debt as the Court of Appeals (the highest court in New York) ruled in 1977 in the case of Quirk v. MAC for City of NY, 41 N.Y.2d 644 (1977).

Unfortunately, financial challenges and distress were compounded by the natural disaster of Hurricane Maria and other ill winds.  The resulting broken infrastructure only magnified the distress and human suffering.  Such human tragedy may blur legal priorities and, to a degree rightfully so, shift the focus of efforts and attention.  Puerto Rico really needs a Marshall Plan to reinvest in Puerto Rico and rebuild its infrastructure and economy.  It appears illogical to ask a government to provide its best proposal for repayment of its debts or creditors to expect the best recovery when the engine for payment, the government’s infrastructure and economy, is struggling to exist.

Congress in 2016 passed the Puerto Rico Oversight, Management and Economic Stabilization Act (“PROMESA”) to provide financial oversight and supervision for Puerto Rico similar to New York City and MAC, Philadelphia and PICA and Washington, D.C. and its Financial Control Board.  PROMESA’s hopeful intent was consensual resolution through the use of Title VI collective action that binds all holders to a resolution with court approval.  Unfortunately, for the first two years of PROMESA, peaceful resolution through Title VI was not the focus.  Under Title VI, a group of holders with as little as 34% of the class of securities can reach agreement with the Commonwealth, vote in favor of the settlement and have the agreement binding on all the holders when approved by the Court.  Contrary to the hope for Title VI resolutions in the first two years of PROMESA, the dynamic uncertainty of the situation continued with the litigious response by creditors and the Commonwealth resulting in little real consensual resolution.  Over a year ago and two years after the passage of PROMESA, the Commonwealth filed for itself and some covered entities a Title III bankruptcy proceeding that permits involuntary resolution if consensual agreement is not reached.  There is some hope with the recent announcements of developing settlements with the Commonwealth, Oversight Board and PREPA bondholders, COFINA bondholders and GDB creditors among others.  Since we are over 28 months since the enactment of PROMESA and over 22 months since the PROMESA Oversight Board was appointed, the lessons learned for the capital market participants from the Puerto Rico financial crisis are now coming clearly into focus:

First, Provide Prompt Need Assistance.  Technical and financial assistance to distressed government should be available as early as possible, and this assistance is critical to a successful, expedited resolution.  PROMESA was needed and helpful but would have been far more valuable in 2006 than 2016.  A PROMESA effort in 2006 would have been quicker, less contentious and possibly more effective and would have avoided between 2007-2016 at least a 23% drop in persons employed, about 290,000 jobs, a labor participation rate of 40% and a population decline of 10%.

Second, Do Not Double Down With Debt.  The financial market in the future should discipline those financially distressed governments that attempt more long-term borrowing without assured ability to pay based on a viable recovery plan.  The financial market in the future should demand, in the name of financial discipline, that a credible recovery plan and restructuring is in place before continuing to provide long-term financing of a distressed governmental entity.  Obviously, maintenance of short-term interim liquidity is essential.

Third, Do Not Abuse Debt Financing Protections.  Governments claiming that bonds have constitutional payment priorities, special revenues and statutory liens must make sure the priorities are binding, enforceable and irrevocable.  Any effort to bait and switch should be treated harshly by the financial market.  Failure to honor such claims could be fatal or costly to future borrowing efforts.  Constitutional priority of payment and structured financings that ring fence revenues are proven methods of protecting public debt.  However, if the infrastructure for providing needed public services is allowed to fall into disrepair or be shattered by an ill wind and the economy is melting, the repayment of debt will be doubtful.

Fourth, We Are All In It Together.  The needed financial recovery will be threatened without acceptable funding for governmental services.  A policy fostering economic development is vital to the attraction of business and the creation of jobs that result in new taxpayers and increased revenues creating the high tide that lifts everyone’s boat.  The ability to be able to repay debt is based on an infrastructure and economy functioning at their peak not their worst.  Puerto Rico aptly demonstrates it is illogical to assume a government can provide its best proposal for repayment when the engine for payment, its infrastructure, is in shambles.

George Washington and Alexander Hamilton, after the Revolutionary War, pronounced the mandate for the Federal Government and the state governments to honor their public debts (calling it the “immortality of public debt”) so that the credibility and sustainability of the new nation could long endure.  It is truly unfortunate and ironic that Puerto Rico, founded on similar principles and assurance for the repayment of public debt, finds itself struggling to do so.  While some argue the territory of Puerto Rico is an aberration, not indicative of state and local governments, Puerto Rico’s struggles for recovery can be a wake-up call that, if heeded, will benefit all.

James E. Spiotto is the co-publisher of and a Managing Director of Chapman Strategic Advisors LLC