The Commonwealth of Puerto Rico is seeking the largest municipal bankruptcy filing in U.S. history, after failed negotiations with creditors over its $70 billion debt crisis. That is more than four times the debt Detroit collapsed under.

As previously reported, U.S. territories were barred from filing for a traditional bankruptcy, permitted for most U.S. cities or states. As a result, the U.S. Congress last year approved the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA) to address the impending financial crisis Puerto Rico was already facing.1

Under the PROMESA legislation signed by former President Barack Obama, the Oversight Board and the Title III process were created. Title III, which is like a Chapter 9 bankruptcy, allows Puerto Rico and other U.S. territories to restructure their debt under the supervision of a federal judge.

On Monday, May 1, 2017 at midnight, a temporary court stay that protected Puerto Rico from lawsuits expired and negotiations with creditors ended.

On Wednesday, May 3rd, the Oversight Board announced it had moved to place Puerto Rico into federal bankruptcy court, invoking Title III. The announcement came a day after major creditors sued Puerto Rico over defaults on its bonds.2

Lawsuits challenge Puerto Rico’s federal oversight board which has allocated roughly $800 million a year over the next decade for debt payments. Creditors however are owed four times that amount annually. Holders of sales-tax bonds called Cofinas sued to prevent Puerto Rico from spending their collateral for other purposes.

Private restructuring talks collapsed when creditors publicly rejected a debt- restructuring offer that would have paid sales-taxed bondholders and general obligation bondholders a maximum of 58 cents and 77 cents on the dollar, respectively. Some of those recoveries were contingent on a broader revival of Puerto Rico’s economy.3

There is also litigation between the holders of the sales-taxed Cofinas and the general obligation bond investors claiming seniority in a restructuring.

In addition, the near $50 billion pension system is underfunded and could be depleted by the year-end. That would shift as much as $1.5 billion to the annual budget, hitting the funding of other public services.4

How did Puerto Rico incur so much debt? In 1917, the U.S. Congress passed a law making Puerto Ricans United States citizens. That same law empowered the island to raise money by issuing tax-exempt bonds and not just federally tax-exempt bonds. Congress went on to bar anyone from taxing Puerto Rico’s bonds – not any state, not any county or city, not the District of Columbia, not any other territories, not even Puerto Rico itself – can tax the interest that Puerto Rico pays its investors. This has spurred people to heavily invest in the island’s bonds. Until last year, investors had an easy guarantee: states and territories are not allowed to declare bankruptcy. Then, to help Puerto Rico during its financial crisis, an exception known as Title III was made to govern territories that want to shield themselves from creditors.

In 1952, Puerto Rico got its own constitution which contained an unusual provision meant to reassure prospective bond buyers. It said that if there was not enough money to pay for everything in the budget, then “all available resources” would go first to pay what was due on Puerto Rico’s general obligation bonds. Today this constitutional guarantee – and what it means under PROMESA – looms as one of the major issues to be resolved.

Now the small Caribbean island – home to 3.5 million people – owes approximately $34,000 in debt per man, woman and child. Their school budgets and other services are all but being cut as part of the austerity planning. As the problem swelled, so, too did the exodus of the educated classes from the island.

On Friday, May 5, Chief Justice John G. Roberts of the U.S. Supreme Court assigned Puerto Rico’s case to Judge Laura Taylor Swain, a federal judge in the Southern District of New York and a former bankruptcy judge. The logistics of the case, which was filed in federal court in San Juan, are not yet clear.

Judge Swain has shown extensive familiarity with bankruptcy law, but the case is still expected to be long and contentious.

Gov. Ricardo Rossello and his predecessor, Alejandro Garcia Padilla, both have taken the view that considering the crisis, they had to put the essential needs of the people first.5

Endnotes

  1. Peluso, Romano I., “Congress Passes Puerto Rico Debt Relief Law,” Perkins Coie LLP, corporatetrustinsider.com, July 5, 2016.
  2. rt.com, Reuters, “’Breaking point’: Puerto Rico files for historic $70bn bankruptcy,” May 6, 2017.
  3. Scurria, Andrew, “Creditors Hammer Puerto Rico as Debt Deadline Passes,” The Wall Street Journal, May 3, 2017.
  4. Platt, Eric, “Title III filing – Puerto Rico investors fear billions of dollars of losses under debt restructuring,” Financial Times, May 5, 2017.
  5. Walsh, Mary Williams, “Even as Puerto Rico Was Buckling Under Debt, Investors Hungered for More,” The New York Times, May 6, 2017.