COFINA

THE SENIOR COFINA BONDHOLDERS’ LETTER

On September 24, 2015, a group of senior bondholders of COFINA, which claim to hold 25% of the principal amount of the debt, sent the Government Development Bank (GDB) a letter objecting to the Puerto Rico Fiscal and Economic Growth Plan’s supposed comingling of COFINA and Commonwealth debt. COFINA bondholders’ position is that this debt is totally separate from Commonwealth debt and by lumping them together, PR Government is violating the Amended and Restated Sales Tax Revenue Bond Resolution. The letter states, inter alia,

Moreover, pages 6 and 65 of the Working Group Plan assume “the clawback of revenues supporting certain Commonwealth tax supported debt” may be available to “service all principal and interest on debt that has a constitutional priority.” While the only lawful interpretation of those passages is that they refer to those bonds that are expressly subject to “clawback,” such significant statements by the Commonwealth should not be left open to interpretation.

These are not minor errors or mere oversights. Rather, the Working Group Plan materially misrepresents the essential nature of COFINA’s indebtedness to the investing public, and materially harms COFINA and its bondholders. It misleads the public by lumping the Commonwealth’s own debt together with COFINA’s (and thus should be treated similar to other Commonwealth debt) when in fact the opposite is true. Specifically, in the Working Group Plan, the GDB and the Commonwealth attempt to consolidate assets and liabilities of COFINA with that of the Commonwealth. There is no doubt that this is intended as a signal to the investing public at large that the Commonwealth’s struggling fiscal health threatens the health of COFINA, ignoring the fact that insulation from the Commonwealth’s other liabilities prompted the creation of COFINA in the first place. Consolidation of COFINA’s debts with the Commonwealth’s obligations will raise future borrowing costs and limit the Commonwealth’s revitalization.

The Working Group Plan’s material misstatements could open up the Commonwealth and all those responsible for the statements to potential liability. . .

Consistent with section 704 of the Resolution, COFINA should promptly cure the misstatements and provide the necessary assurances of rights of bondholders under the Resolution. It is important that you promptly perform your ministerial duty to untangle the COFINA debt and revenue from that of the Commonwealth. Doing so is necessary to avoid a breach of the Resolution and potential liability, and to fulfill the clear legal commitments made by the Commonwealth.

The purpose of the letter is not clear at first glance and an explanation is needed. The PR Government, probably under the advice of Millco Advisors and Cleary Gottlieb, has been trying to create a conflict between COFINA bondholders and GO bondholders. The old idea of “divide and conquer”. Each time a COFINA bond issue was done, there were three legal opinions stating that the revenue from the sales tax would not be part of the available revenues for payment of GO’s as per the Constitution. In other words, COFINA funds could not be used to pay GO’s. Whether this is true, it is irrelevant at this stage, but COFINA bondholders do not want the Government hinting that it could happen as the Puerto Rico Fiscal and Economic Growth Plan hints.

In the letter, COFINA bondholders demand that PR make a clear statement that their funds cannot be used to pay GO’s (as the PR Department of Justice has said every time there is a bond issue). What if PR does not make this clear statement? Here is where the COFINA AMENDED AND RESTATED BOND RESOLUTION comes in.

The letter requires the GDB to comply with its ministerial duty, i.e., if you don’t comply, I am going to slap you with a mandamus, which is a special writ in equity or complaint to require the Government to do something which is part of its ministerial duties, this duty being, protecting bondholders’ position of NO CLAWBACK. Moreover, the COFINA Bondholders’ Resolution at page 79, states as follows:

In addition, the Trustee may, and upon the written request of the Owners of not less than twenty-five per centum (25%) in principal amount of the Outstanding Bonds, shall, proceed to protect and enforce its rights and the rights of the Bondowners by such of the following remedies, as the Trustee, being advised by counsel shall deem most effectual to protect and enforce such rights subject to the provisions of Sections 201, 803 and 1206:

. . .

(iv) by action or suit in equity, to enjoin any acts or things which may be unlawful or in violation of the rights of the Bondowners or the Beneficiaries.

The COFINA bondholders have a very solid legal point that they can sue in equity to force the GDB and COFINA to make such statement. If a suit ensues, it will be difficult for PR to claim that clawback is possible since the Secretary of Justice has said time and again it cannot occur. Question now is, will COFINA bondholders follow through on their threat, and if so, in which court?

LEGAL RAMIFICATIONS OF PUERTO RICO NOT PAYING BONDHOLDERS

What are the legal consequences of Puerto Rico not paying bondholders? Can Puerto Rico be sued? In which Court? Who can sue? All these are important questions for investors and the general public after Standard & Poor’s and Moody’s downgrades, which include the latter’s actions on the COFINA backed bonds.  Here, I will try to predict the possible scenarios.

The most obvious is that PR, nor any state of the Union, can file for US Bankruptcy law protection for the Code does not provide fro them to do so. In addition, none of PR’s municipalities or public corporations may do so. Not only does PR law expressly allow it, but 11 U.S.C. § 101(52)  expressly excludes PR and Washington DC from Chapter 9 protection. Hence, the organized reorganization that Detroit is undergoing is not possible for PR.

Puerto Rico is not an independent country nor is it a state of the Union. It is a self-governing non-incorporated territory of the United States, see, Harris v. Rosario, 446 U.S. 651 (1980). But for purposes of the Eleventh Amendment, it is a state, see, Fresenius Medical Care Cardiovascular Resources, Inc. v. Puerto Rico and the Caribbean Cardiovascular Center Corp., 322 F.3d 56, 61 (1st Cir. 2003). This Amendment was incorporated on the heels of Chisom v. Georgia, 2 U.S. (2 Dall.) 419 (1793), which decided that a state of the Union could be sued in Federal Court, even if it could not in its own courts. Soon after, the Eleventh Amendment was enacted and approved. Hence, PR cannot be sued in Federal Court without its consent.

PR has given its consent to be sued in its own courts for breach of contract, see, Hato Rey Stationery, Inc., v. Commonwealth of Puerto Rico, 19 P.R. Offic. Trans. 153 (1987)  and Montalvo & Comas Electric Corp. v. Commonwealth of Puerto Rico, 7 Offic. Trans. 613 (1978). The inquiry, however, does not end there.

Although it is usually agreed that PR owes around $70 billion, not all of the debt is owed by the Commonwealth of Puerto Rico, the official name of the island’s government. According to slide 56 of The Commonwealth of Puerto Rico,  Update on Fiscal and Economic Progress, FY 2014 Q1 Investor Webcast – October 15, 2013 , has a general breakdown of who owes what. This brings several issues to bear. Public corporations such as the PR Electric Power Authority that generate their own income are subject to federal court jurisdiction and these owe around $25 billion. In addition, municipalities owe over $3 billion and are not protected by the 11th Amendment. Moreover, only $16.233 billion which is GO debt backed by the full faith and credit of PR are Constitutionally protected and are required to be paid before anything else, see, Article VI, sections 2 and 8 of Puerto Rico’s Constitution, available here in English.

Hence, the bond holder or the insurance company that subrogates on its insured’s rights, has to examine who is the issuer of the debt, what if any 11th Amendment protection it may have and then determine where to sue for collection of moneys.

This does not mean that bond holders or their agents or subrogees will collect from PR. The island may unilaterally change the conditions of the contract. The guarantee against the impairment of contracts provided by the Contract Clause of the US and Puertorrican Constitution have been greatly eroded in the past years. This can be seen in United Auto., Aerospace, Agr. Implement Workers of America Intern. Union v. Fortuño, 633 F.3d 37 (1st Cir. 2011); Trinidad v. ELA, 2013 TSPR 73 and Domínguez Castro et al. v. E.L.A. I, 178 D.P.R. 1 (2010), cert denied, Domínguez Castro v. Puerto Rico, 131 S. Ct. 152  (2010).  This means that it is very likely that a court could conclude that PR may put a temporary moratorium or even repudiate part of its debt or that of its political subdivisions. Such a step would be radical and I doubt if the present administration would even consider it, but it is there to consider.