PUERTO RICO’S REPUDIATION OF GENERAL OBLIGATION BONDS: A REAL RISK OR JUST KABUKI THEATER
By James E. Spiotto
On January 14, 2019, the Financial Oversight and Management Board, acting through its Special Claims Committee and the Official Committee of Unsecured Creditors, filed an objection to the validity and enforceability of more than $6 billion of the Commonwealth of Puerto Rico’s General Obligation Bonds. The purported reason for the invalidity was the asserted violation of the Commonwealth’s Constitutional Debt Service Limit found in Article VI, Section 2 of the Puerto Rico Constitution, as amended in 1961, which provides that direct obligations of the Commonwealth “shall not exceed 15% of the average of the total amount of annual revenues…” (“G.O. Debt Limit”). This claim of invalidity was asserted long after the issuance of the General Obligation Bonds, in which the Commonwealth and its professional represented that the Bonds complied with the Constitution and laws of Puerto Rico and were a valid, binding and enforceable obligation, and released to the market a calculation of compliance of the issuance with the G.O. Debt Limit. In addition, there also is a claim by the objecting parties that issuance of the $6 billion of General Obligation Bond Debt violated the Balanced Budget Clause of the Puerto Rico Constitution, Article VI, Section 7 providing “the appropriation made for any fiscal year shall not exceed total revenues including available surplus estimated unless the imposition of taxes sufficient to cover said appropriation is provided by law” (“Balanced Budget Clause”). These claims of invalidity when carefully reviewed from a historic perspective should be rejected.
Repudiation or claims of the invalidity of previously issued general obligation bonds by states or even local governments historically have never been viewed by the market as an acceptable or respectable position for an issuer who had earlier represented, through its statements and its agents, that the bonds were valid and in compliance with the law. Generally, constitutional debt limits or balanced budget requirements are guide posts for the governmental issuer in conjunction with bond counsel prior to actual issuance to determine whether such debt can and should be incurred. These provisions were not intended to create an artifice that clever government issuers could spring on unsuspecting good faith bond purchasers who had no prior notice of any defect and in fact were told at issuance there were no compliance problems with the constitution and law of the government. Nevertheless, efforts by states and local governments to repudiate or invalidate debt after its issuance contrary to what they represented to induce the purchase of bond debt by good faith purchasers are not new. Such attempts to invalidate or repudiate state and local government debt in the United States first took place in the 1800’s. The lessons learned from those unfortunate efforts should not be forgotten and are instructive as to the current attempts of Puerto Rico to invalidate certain of its G.O. Debt.
History of Repudiation
In the aftermath of the panic of 1837 and the need for states to borrow to pay for transportation improvements in the North (given the success of the Erie Canal) and for banking services in the South, 19 out of 26 states and two territories borrowed money for economic growth. By the 1840’s, eight states and one territory defaulted on those borrowings and repudiated those debt obligations. Those issuers that repudiated the debt then experienced either an inability to borrow additional funds or, if they could obtain financing for needed governmental improvements and services, suffered the imposition of a 32%+ yield. By the late 1840’s, seven of the eight states had renounced their repudiation and resumed payment on the debt in order to obtain market access at a lower cost. The state and one territory that were left repudiating their debt struggled for over a decade to obtain funds, let alone at a reasonable cost.
After the Civil War, in response to suggestions that the government should discount the cost of war debt by paying it in greenbacks as a devalued currency, President Grant, in the spirit of Washington and Hamilton eighty years earlier, chose to protect national honor. He stated every dollar of the government indebtedness should be paid in gold. Unfortunately, such was not the fate of the failed confederate government’s war debt. By means of the 14th Amendment, debt incurred in aid of insurrection was deemed illegal and void.
After the Civil War, eight southern states (Alabama, Arkansas, Florida, Georgia, Louisiana, Mississippi, North Carolina and South Carolina) repudiated their outstanding indebtedness and have never rescinded that repudiation. The reasons vary but generally are attributable to debt involuntarily incurred during the “carpet bagger” governments. The southern states believed these debts were not legitimately incurred by the state for the benefit of the people due to the profiteering of the transition government staffed with northern appointees. The stigma of those repudiations still remains.
State courts in the 19th century were often sympathetic to the position of governmental issuers, both as to actions to enforce the bond contract or equitable remedies. However, in 1858, the United States Supreme Court in Commissioners of Knox County v. Aspinwall, 62 U.S. 539 (1858) ruled that recitals by the issuer in bond documents representing that the bonds were validly issued estopped that issuer from disputing the truth of the representations as against a bona fide purchaser of the bonds. This ruling formed the basis for the famous railroad cases.
These cases were the result of issuances by various states and municipalities during the second half of the 1800’s in connection with railroad expansion. This was done by governments using the proceeds of public debt to build facilities in the hope that a railroad would come or utilizing those funds to invest in the railroad to induce the railroad to lay tracks in their direction. Unfortunately, numerous communities found that the railroad took a different course. Thereafter, towns sought to repudiate the debt as not serving a public purpose. Hundreds of cases between 1860 and 1896 made their way to the U.S. Supreme Court. The Supreme Court took a consistent and clear stand upholding the validity of the bonds, sometimes overruling state supreme courts that had issued orders essentially reversing prior state court holdings that the bonds were valid and binding. The Supreme Court ruled that the efforts of state and local governments to repudiate and invalidate bonds issued to subsidize the railroad facilities violated the Constitution, and the Court established rights of bond investors.
When Invalidity Is an Unwillingness to Pay, Despite Past Representations
The High Court and many federal courts consistently supported bondholder rights in cases, like the current Puerto Rico dalliance with unwillingness to pay, when municipalities and state supreme courts attempted to invalidate/repudiate debt issued to good faith bond purchasers for good value provided to the government and the bond purchaser relied on the representation of the government issuer that all requirements for the valid issuance of the debt had been fully complied with prior to issuance. The U.S. Supreme Court in a series of decisions, especially in its October 1875 term, reaffirmed a rule that previously had been followed in earlier U.S. Supreme Court decisions and even earlier common law rulings of England’s Court of the Exchequer. Namely, the claims of a bona fide holder of bonds against a state or local government issuer, in reliance upon recitals and representations at the time of issuance that the bonds were issued in full compliance with all requirements of the laws and constitutional provisions as determined by the issuer and its agents prior to issuance, must prevail. The recitals and representations are conclusive. This is more emphatically true when the conclusive determination is one peculiarly within the knowledge of the persons to whom the power to issue bonds has been granted, namely, the state or local government. See Town of Coloma v. Eaves, 92 U.S. 484 (1875); County of Moultrie v. Rockingham Ten-Cent Savings Bank, 92 U.S. 631 (1875); Marcy v. Township of Oswego, 92 U.S. 637 (1875). These cases focus on the party best able to detect any defect, which as a general rule, is the issuer.
In the Township of Oswego case, the Court was faced with the post-issuance questioning of the debt limitation being violated. The Supreme Court noted the prerequisite to issuance of debt is to answer the question of there being “sufficient taxable property to warrant the amount” of the bonds and that decision has been referred to the inquiry and determination of the issuer before bonds can be issued to bona fide bond purchasers. Accordingly, the bona fide bond purchaser is not required, when purchasing the bonds, to look beyond the acts of the government and its recitals/representations as to compliance with the constitution and laws of the state as contained in bonds and related documents. The Court rejected any belated post-issuance effort by the government to claim that the bonds were invalid due to a violation of the debt limit.
Invalidity Without Past Representation of Compliance
Some may note the U.S. Supreme Court has approved invalidating bonds that have violated the constitution and debt limits but in very different circumstances. See Buchanan v. City of Litchfield, 102 U.S. 278 (1880). However, the Litchfield ruling clearly pointed out that the failure to have any recitals or representations as to full compliance with constitutional provisions relating to debt limits and the failure to have any assessment valuation for the relevant year permitted the question of invalidity. The Court further noted that such questioning that would not be viable if there had been the recitals and representations made as was done in Knox County, Township of Oswego, Town of Coloma and the other cases previously decided by the U.S. Supreme Court. Clearly, the basis for Puerto Rico’s claim of invalidity of its general obligation bonds was rejected by both Litchfield and Township of Oswego decisions. Even the Certificates of Participation (“COPs”) of the Detroit case, cited by the Puerto Rico movants, where the Emergency Manager claimed the COPs were the product of a “criminal mayor” and purportedly unsupported by any state statute or other precedent, resulted in a settlement, not a zero recovery for the investors.
This enforcement of the principal of estopped is consistent with Article 8 Section 8-202 of the Uniform Commercial Code.
Puerto Rico has adopted this provision that permits restitution to bondholders even if there is a constitutional violation if there has been substantial compliance with legal requirements, the issuer has received substantial consideration, and the issuer had the power to borrow money for the stated purpose.
Puerto Rico Made a Constitutional Representation and Calculation of Compliance with the Debt Limit
Puerto Rico in connection with the issuance of the asserted invalid general obligation bonds not only stated specifically that the bonds were in full compliance with the Constitution and laws of Puerto Rico but also, in the Official Statement, detailed the calculation and determination by Puerto Rico that the G.O. Debt Limit was not violated. It is illogical and unrealistic to require or expect the bona fide bond purchaser to be better able to perform the calculation than the government issuer, who is the one tasked to make the determination before issuance of the bonds. Further, there were opinions of counsel based on the representations of the Commonwealth that provided further assurance that the bonds were legal, valid, binding and enforceable.
The Commonwealth argues that, under Puerto Rico law, the Commonwealth cannot be “estopped” from now claiming the general obligation bonds are invalid in violation of the Constitutional debt limit. But as the U.S. Supreme Court cases in the 1800’s ruled with respect to state and local governments, findings made by the one tasked with the determination required before issuance of the bonds are conclusive determinations not to be revisited as an excuse for unwillingness to pay when repayment is inconvenient or undesirable. Further, the problem of Puerto Rico in complying with the Balanced Budget Clause is an issue of budgetary discipline of the government, not the fault of an unsuspecting good faith bond purchaser that has given hard dollar consideration for the Commonwealth’s paper promise. Questions of English or Spanish interpretations of what are “available revenues” or “available resources” cannot erase or reverse the announced conclusive and final determination of full compliance with the Constitution and laws of Puerto Rico made prior to and in connection with the issuance of the bonds. Claims of violation of the G.O. Debt Limit are not the end of the controversy, but only a new beginning where equitable remedies replace legal rights such as unjust enrichment, restitution, estoppal and equitable trusts or liens on funds paid by the bondholders or tracing the proceeds thereof. The result of claims of invalidity, despite representation to the contrary, is legal meltdown.
To oversimply the Commonwealth position, it seeks to repudiate and invalidate this debt due to its current newly discovered finding that certain general obligation bonds violate the Constitutional G.O. Debt Limit and Balanced Budget Clause, and therefore the Commonwealth should not be responsible for that debt. As we all know, if a corporation or an individual issued debt in the public market representing that debt was a valid, binding and enforceable obligation and then later, when it was inconvenient or difficult to pay, claimed it was never authorized to incur the debt, there would be serious and dire consequences. That corporation or individual would be open to a flood of litigation, if not criminal investigation, claiming fraud on the investors. As the U.S. Supreme Court has ruled long ago, such a contention is not tenable for governmental issuers.
Could Washington and Hamilton Be Wrong?
It should be remembered that “No pecuniary consideration is more urgent than the regular redemption and discharge of public debt. On none can delay be more injurious or an economy of time more valuable.” These were the words of George Washington, over 220 years ago, in his State of the Union address on December 3, 1793. Washington and Hamilton were instrumental in having the Federal Government assume the states’ debt from the Revolutionary War since some states were balking at paying such debt. Those states feared their good tax dollars would go to pay Northern speculators (who purchased the debt at a discount) or the debt of other states who were big borrowers. Washington and Hamilton knew that the progress of the nation could be no swifter than its financial credibility. The Federal Government assumed the states’ Revolutionary War debt to avoid repudiation and to assure financial credibility on the federal and state level. Now, there are echoes of this same debate over 225 years later. Will there be the same result?
Accordingly, the claims by Puerto Rico that it was not authorized to issue the debt, despite resolutions, statements and opinions representing the contrary to the capital market, appear disingenuous at best. Further, at the time of issuance, there was no outcry of lack of authority. To the contrary, Puerto Rico received and retained the benefit of that purported unauthorized issuance. Assuming Puerto Rico’s claim of invalidity had merit, fairness would require Puerto Rico to return the proceeds of the “invalid” bonds to the bona fide purchasers that purchased them because retention of those ill-gotten funds would be unjust as the U.S. Supreme Court has so ruled.
THE QUESTION IS WHETHER THE REPUDIATION OR INVALIDATION OF OVER $6 BILLION OF PUERTO RICO GENERAL OBLIGATION BONDS IS GOING TO HELP PUERTO RICO REGAIN FINANCIAL CREDIBILITY AND WILL NOT SOUR MUNICIPAL MARKETS AGAINST PUERTO RICO’S FUTURE DEBT AS WELL AS IMPAIR ITS ABILITY TO ATTRACT REINVESTMENT.
The inevitable consequences to Puerto Rico and to the municipal market, upon which all states and municipalities rely for funding their long-term capital improvements and sometimes their essential services, cannot be tolerated. If past history is a judge, the difference in the market between the better credits and the weaker credits may range from 200 basis points or more of additional annual interest costs. Given Puerto Rico’s need to reinvest in Puerto Rico and borrow significant sums to do so in the future, Puerto Rico could possibly pay at least 200 basis points or 2% more a year for future borrowings. That additional interest cost will be a heavy penalty. Additional 2% annual interest cost for a 20-year bullet maturity bond at a 5% discount is a present value cost of about 25% of the original principal amount. That additional 25% of the principal of future borrowing can be just the price that prevents full economic recovery and reinvestment in Puerto Rico. It would divert the additional 25% of principal from being used to pay for infrastructure or essential services, public workers’ salaries or pensions, other creditors or tax relief to the taxpayers.
While the correctness of past determinations of compliance with the Constitution and law may be debated, there should be no doubt that good funds were provided by investors, that benefits were received by Puerto Rico through its use of those good funds and a public benefit was achieved. It strains the notion of fairness and justice if a benefit can be retained but the consideration for it can be repudiated. Repudiation of the General Obligation Bonds may create little public benefit and substantial long-term public pain. Washington and Hamilton warned and history has demonstrated that “no pecuniary consideration is more urgent than the regular redemption and discharge of public debt.” The best test of a fair and just result is whether the outcome can be explained to a young child. It is doubtful any third grader would understand or support the proposition that a person could retain the benefits received from a transaction without suffering the burden of paying the agreed-upon consideration. Perhaps the simple, moral and practical answer is the hardest for some to comprehend.
It is interesting to note that constitutional debt limitations were placed in numerous state constitutions in the latter half of the 19th century, after a number of states repudiated excessive debt obligations as noted above. The limitations were intended to protect and shield both states’ citizen taxpayers and bondholder from unnecessary and extravagant debt and bond defaults. Presently, 47 states have such constitutional or statutory debt limits. Puerto Rico’s present claim of invalidity of G.O. Bonds due to a violation of the Constitution Debt Limit is an unfortunate attempt by Puerto Rico to turn what was intended to be a shield for the protection of bondholders into a sword to be used against them.
James E. Spiotto is Managing Director of Chapman Strategic Advisors, LLC and Co-Publisher of MuniNet Guide.