For the first time in American history, a United States territory will seek what is essentially bankruptcy relief in federal court. Puerto Rico made headlines today with the Financial Oversight and Management Board’s (FOMB) decision to approve the usage of Title III to restructure the island’s debt. Although the move is unfortunate, it was our view that Title III was an eventual inevitability. The implementation of Title III does not change the Commonwealth’s situation: It has already defaulted and must restructure its debt. The Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) was enacted to address the island’s high degree of indebtedness, and Title III is the tool that will now be used to restructure those obligations, although consensual negotiations can still play a part as the Commonwealth and creditors continue to talk. Readers may remember that Title III was one of two options provided under PROMESA, the second being Title VI, which would involved a consensual renegotiation of debt. Importantly, Title III is a court-supervised bankruptcy-like process that does still provides certain debtor and creditor protections. Puerto Rico will not have the carte blanche ability to dictate treatment and recoveries.
This latest development follows the release of the Commonwealth’s restructuring proposal and general-obligation counterproposal. We will look a little deeper at those and what this all means for the future for Puerto Rico and the broader municipal market.
The Commonwealth’s eleventh-hour restructuring proposal, released at midnight April 30, was soundly rejected by creditors. The proposal’s release came just 24 hours before the stay on litigation provided by PROMESA was set to expire. The reasons for the rejection are very clear when we look not just at the scarce recoveries but also at the treatment of Sales Tax Financing Corporation (COFINA) creditors. The proposal called for an initial payout of 52.4 cents on the dollar to general-obligation and 39.2 cents to COFINA bondholders. Under the cash-flow or hope-bond concept included in the proposal, GO and COFINA bondholders could achieve respective payouts of 77.4 cents and 58 cents if the island’s economy met certain growth milestones. The proposal also provided “pari passu” treatment of COFINA senior and junior bondholders, meaning payouts would be distributed at equal rates between the two classes of creditors. This blatant disregard of COFINA creditors’ rights and claims meant the proposal was dead on arrival and a non-starter for any serious negotiations. Successful negotiations must start with some common ground and understanding anchoring them, even if the degree of each is slight. The attempted modification of bondholders’ claims on revenue and the comingling of them into a common fund amounted to substantive consolidation. This is an unusual remedy that bankruptcy courts use sparingly and only when a number of factors are considered. If the island’s goal was to release a proposal that would get zero support, then they accomplished that goal with amazing precision.
Puerto Rico followed the release of the failed restructuring proposal with a general-obligation (GO) counterproposal that offered a much higher recovery rate to general-obligation bondholders. It provides a 70% recovery in new senior bonds and 20% in senior cash-flow bonds. There would also be no mandatory principal payments until June 30, 2026. This counterproposal is substantially higher than the Commonwealth’s prior offer of 77 cents on the dollar. This, of course, would be dependent on the outcome of COFINA litigation.
The latest restructuring proposals clearly highlight the Commonwealth’s “favoring” of general-obligation bondholders. We would argue that this tactic is extremely flawed and that COFINA offers the island a better path to market access than GO bonds. Market participants, ourselves included, have lost all faith in the constitutional guarantee of GO bonds. The guarantee has clearly not prevented defaults or comforted investors as they have watched the value of uninsured debt deteriorate. A constitutional pledge is only as good as the ability and willingness to enforce it.
What Title III relief means for the broader municipal market is an important question. We think the implications reach far beyond the shores of Puerto Rico, especially with regard to COFINA and securitized debt structures. COFINA was sold to investors as offering “stronger” legal protections than their constitutionally guaranteed debt with revenues that were not “available resources” at the Commonwealth’s disposal. When the rubber hit the road and the Commonwealth’s ability to pay was impaired, it chose its citizens over bondholders. We make no judgment on this point and offer no opinion. Balancing debtor and creditor interests is extremely complicated and generally requires more than a simple solution. This may be the biggest lesson Puerto Rico can offer. Contractual obligations and sound legal structures may not prevent haircuts.
Assuming that further consensual negotiations aren’t fruitful, it now will be up to a judge to decide how the story plays out. We do not expect the court to disregard well-established bond law, but anything can happen in a bankruptcy. We do not recommend the purchase of uninsured Puerto Rico debt, as there are still too many unknowns to estimate realistic recovery values. We remain confident that Assured Guaranty and MBIA can meet all necessary obligations and continue to be “money good.” Their financial strength and expertise remain a driving force, and insured Puerto Rico paper continues to offer an attractive opportunity to investors. We look to take advantage of any headline-driven movement in yields.
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