By LEN WEISER-VARON and BILL KANNEL

Last week, the Working Group for the Fiscal and Economic Recovery of Puerto Rico gave the broadest hint yet of the next tactic in Puerto Rico’s ongoing quest to deleverage itself.  Although the details have not yet been articulated, Puerto Rico apparently proposes to blend into a single pot several types of distinct taxes currently earmarked to pay or support different types of bonds issued by a number of its legally separate municipal bond issuers, with the hope that the resulting concoction will meet the tastes of a sufficient number of its differing bond creditors to induce them to voluntarily exchange their various types of bonds for a single type of new debt presumably supported by the new blended tax revenue stream.

According to the “Restructuring Process and Principles” slides released by the Working Group on September 24, “the Working Group is working with the Commonwealth’s advisors to structure a debt-relief transaction that will permit the Commonwealth’s available surplus to be used to make payments on its indebtedness while the initiatives and reforms undertaken as part of the Fiscal and Economic Growth Plan take hold.”  Per the release, “[t]he consensual negotiation and ultimate transaction will seek to involve not just creditors of one governmental entity, but instead the creditors of many entities, as part of a single, comprehensive exchange transaction. The  goal of this approach is to avoid a piecemeal strategy that may result in uncoordinated and inconsistent agreements with creditors, litigation among creditor groups, and a lower chance of success.”

As the saying goes, good luck with that.

The Working Group’s trial balloon is short on details as to which existing debt would be involved in the contemplated “single, comprehensive exchange transaction.”  Given the magnitude of the Working Group’s projected funding gap,  after other proposed corrective measures are undertaken, of $14 billion from FY 2016 to FY 2020, and given that direct and guaranteed general obligation bonds and COFINA sales tax bonds  constitute approximately $34 billion out of Puerto Rico’s approximately $71 billion in outstanding public sector bonds, it seems virtually certain that, at a minimum, the contemplated “super-exchange” would involve the g.o. bonds and the COFINA bonds.  Other types of bonds supported, directly or on a contingent basis, by Commonwealth tax revenues are of substantially lesser magnitude and, in many instances, also are payable from independent revenue streams. Some or, depending on the Working Group’s appetite for complexity, all of those other types of bonds also are likely to be targeted for the to-be-negotiated “super-exchange”; as listed in the Working Group‘s September 9 report, they include bonds issued by HTA, GDB, PBA, PFC, PRIFA, UPR, PRCCDA, PRIDCO, GSA and ERS.

In evaluating the feasibility of a negotiated exchange that stirs together this alphabet soup of issuers and creditors, we start from the following premises:

  •  Debt service on the g.o. debt has top priority, under the Puerto Rico constitution,  on the Commonwealth’s “available resources.”  Although enforcement of this legal priority would raise some thorny issues, and although much of the g.o. debt may now be held by holders with a basis well below par, there is no clear incentive for many g.o. bondholders to give up  any portion of their legal entitlement to full debt service payment from “available resources” for what the Working Group’s slides characterize as reduced payment from the Commonwealth’s “available surplus.”
  • Debt service on COFINA bonds is payable from a statutorily assigned portion of the sales tax or of any substitute tax such as the VAT.   The statutorily assigned taxes should be sufficient to pay full debt service on the COFINA bonds for the foreseeable future.  Puerto Rico case law as well as a series of Puerto Rico Attorney General opinions support the validity of such an assignment.  Much of the outstanding g.o. debt has been issued and/or purchased with full awareness by the g.o. bondholders that the relevant portion of the sales tax has been assigned to COFINA and its bondholders.  Similar assignments of specified tax revenues to independent bond-issuing authorities have been upheld in other jurisdictions.  The complaint allegedly ready on someone’s shelf seeking an adjudication that the COFINA structure is a legal sham or that the assigned sales tax revenues remain “available resources” for the payment of g.o. debt service may be filed some day, but from our perspective COFINA holders should like their chances in any such litigation.  Absent disproportionate fear of an adverse result in any such litigation, there is no clear incentive for many COFINA bondholders to give up  any portion of their legal entitlement to full debt service payment from the statutorily assigned and pledged sales tax revenues for reduced payment from any other source.
  • What, if anything, could be achieved by Puerto Rico in consensual debt reduction negotiations with holders of other types of debt with more tenuous claims on Commonwealth taxes (due to express clawback provisions, appropriation requirements, lack of a constitutional payment priority or security interest or other factors) is an interesting question, but may be moot in the event of substantial nonparticipation in a “super-exchange” by g.o. and COFINA bondholders, as Puerto Rico cannot achieve the debt service reductions it asserts it needs without substantial buy-in from the g.o. and/or COFINA bondholders.
  • Although the “Restructuring Process and Principles” slides state that “[t]he transaction will be structured to take into account the priorities of the debt that creditors hold”, it is difficult to derive much meaning from that statement.  Any restructuring that reduces debt service payable on the g.o. bonds in order to pay other Commonwealth expenses will disregard the constitutional priority of debt service in application of available resources.  Any restructuring that reduces debt service payable on COFINA bonds in order to apply some of the sales tax/VAT pledged as security to COFINA bonds to instead pay Commonwealth expenses will violate the statutory priority of COFINA bond debt service.  To the extent that the restructuring would be consensual, it may be tautological that there will be no dishonoring of any constitutional or statutory priority, as the participating bondholders will have agreed to any deviation from such priorities.  If one assumes that Puerto Rico intends to seek concessions from the g.o. bondholders and/or COFINA bondholders, the statement that priorities will be “taken into account” in the proposed “super-exchange” can best be read as a statement that other types of tax-supported debt to be included in the proposed “super-exchange” may be offered less favorable exchange ratios than the g.o.’s and/or COFINAs.
  • The difficulties and uncertain outcome of consensual debt reduction negotiations involving PREPA, a single credit payable solely from electricity revenues widely deemed insufficient to cover the associated revenue bonds, do not bode well for the outcome of consensual debt reduction negotiations involving homogenization of numerous separate credits, including some with strong legal claims for full payment of their debt.
  • Negotiated exchanges involving some degree of municipal debt reduction or bondholder concessions have succeeded in certain other contexts, but few that we are aware of in which the issuer did not have access to a bankruptcy option as an alternative. Successful exchanges involving issuers that did not have access to a bankruptcy process (e.g., certain tribal casino bonds) involved debt that did not benefit from strong legal claims on tax revenues of the type held by Puerto Rico’s g.o. and COFINA holders.

Puerto Rico’s announced strategy for dealing with its debt has evolved from ring-fencing its tax-supported debt and attempting to address its public corporation debt with a Puerto Rico bankruptcy statute to targeting its tax-supported debt in a consensual negotiation process.  The Working Group and its advisors may sincerely believe that a “debt lite” consommé can emerge from such pot-stirring, but may also believe that a failed process will provide additional ammunition for what Puerto Rico really wants to address its unwieldy debt structure: enactment of federal “super Chapter 9” legislation that would give it access to a federal bankruptcy process encompassing its g.o. bonds as well as its public corporation debt.

By LEN WEISER-VARON and BILL KANNEL

Last Tuesday, Puerto Rico sold its much-ballyhooed $3.5 billion in non-investment grade general obligation bonds.  Two days later, two legislators in Puerto Rico’s Senate filed a bill which, if enacted, would permit insolvency filings by Puerto Rico’s public corporations in Puerto Rico’s territorial trial court.  The juxtaposition of the two events has some bond investors crying foul.  But though the timing of the insolvency bill must have Puerto Rico’s investor relations personnel swallowing ibuprofen, Puerto Rico itself is not a “public corporation” and the proposed legislation would not establish a process for an insolvency filing affecting the territory’s general obligation bonds.  (Although the legislation authorizes a bankruptcy-like process, the process is referred to in this post as “insolvency”  to distinguish it from the federal bankruptcy process.)

The proposed legislation is of greater interest to holders of bonds issued by Puerto Rico’s public corporation bond issuers.  To the extent the legislation responds to requests by one or more public corporations, it is not good news for bondholders, as it suggests that some of those public corporations may be actively considering an insolvency-related process.  However, press reports indicate that Puerto Rico’s Governor opposes enactment of this particular legislation.  Accordingly, the existence of the Senate bill, and its details, may deserve attention not so much because of any likelihood that such an insolvency process will be implemented in the short term, but rather as a case study in the legal complexity of any attempted restructuring of Puerto Rico’s governmental debt.

Whether legislation of the type represented by the Puerto Rico Senate bill, if enacted, would be constitutional would likely involve years of litigation following an attempt by any public corporation to avail itself of such protection as it provides.  As suggested in the bill’s preamble, Puerto Rico’s authority to create its own non-federal process to address insolvent public corporations is uncertain.  Puerto Rico’s instrumentalities are excluded from the definition of “municipality” under Chapter 9, which governs municipal bankruptcies.  Whether under the U.S. Constitution’s supremacy and bankruptcy clauses the existence of Chapter 9 preempts Puerto Rico’s ability to establish its own bankruptcy-like process for its public corporations, or whether Puerto Rico’s exclusion from Chapter 9  suggests that Congress did not intend such preemption, is the main constitutional question.  Further complicating the resolution of that question is Puerto Rico’s status as a federally-approved U.S. territory that has been recognized as akin to a “state” for at least some constitutional purposes by the U.S. Court of Appeals for the First Circuit.

If legislation of the type filed in Puerto Rico’s Senate were enacted, and if the constitutionality of such a non-federal insolvency process in Puerto Rico were ultimately upheld, such legislation by its terms limits a public corporation’s ability to restructure its debts.   The legislation precludes a “significant” impairment of the public corporation’s major contractual obligations unless it is reasonable and necessary to serve an important public purpose.  The legislation defines an “important public purpose” as including (somewhat perplexingly) the obligation to comply with existing contracts, but, perhaps more significantly, as including “the stability and continuity of essential public infrastructure, utilities and services.”   In other words,  the bill would create a “bankruptcy-lite” statute designed to permit approval of restructuring plans only to the extent they satisfy the federal constitutional test for impairment of contracts.  The “contracts clause” of the U.S. constitution has been judicially interpreted not as a prohibition on contract impairment but rather as a balancing test under which contracts may be impaired if there is sufficient public necessity for doing so and there are no less onerous means of addressing such public necessity .

The limits on what can be achieved under the proposed legislation are compelled by the fact that, if it were enacted, in contrast to Chapter 9 it would not be enacted under Congress’s constitutional power to provide a bankruptcy process.  Whereas the constitutionally-sanctioned federal bankruptcy act expressly contemplates certain judicially approved contract impairments to give a debtor a “fresh start”, a Puerto Rican public corporation insolvency statute not enacted pursuant to the constitutional bankruptcy provisions would need to comply with the anti-impairment provisions of the U.S. Constitution.  Accordingly, any plan under a Puerto Rico statute that impairs bondholder rights would be subject to challenge on whether the statute’s definition of “important public purpose”  correctly incorporates the federal constitutional balancing test for permissible contract impairment and, if so, whether that test has been properly applied in the context of any particular impairment by any particular bonding authority of particular bondholder rights.   This is an inefficient process relative to the federal bankruptcy statute, which provides a process for bankruptcy plan approval that obviates the need to address on a case by case basis whether an approved contract impairment is constitutional.

The bill introduced in Puerto Rico’s Senate reinforces a risk already faced by Puerto Rico bondholders that Puerto Rico may seek by direct legislation or by legislatively-established process to impair to the extent constitutionally permissible the contractual rights of bondholders of insolvent bonding authorities.  That risk is already playing itself out for a different class of Puerto Rico’s creditors, its public employees and teachers, in legislation imposing certain pension cuts and in court challenges to such legislation.  If there is good news for Puerto Rico’s public corporation bondholders in the specific legislation filed in the Puerto Rico Senate, it is that the insolvency process outlined in such legislation, unlike the federal bankruptcy statute,  lacks a “cramdown” provision and would require approval of any restructuring plan by 75% in amount of affected creditors.  In other words, any cutbacks in bondholder rights under the proposed legislation would, in most conceivable instances, require the consent of a substantial proportion of the bondholders.

BY LEN WEISER-VARON

Restructurings of tax-exempt bonds payable by an entity experiencing financial difficulties typically feature the yin of an obligor seeking debt relief that will permit it to operate without the stigma of potential insolvency and the yang of creditors who may wish to accommodate but do not want to leave money on the table.  This often leads to some variant on an “A/B” structure involving a reduced amount of debt that is unconditionally payable (the “A piece”) and a balance that is deferred and often payable on a flexible schedule dictated by available cash flow (the “B piece.”)

However, maintaining tax-exemption of the bonds often presents obstacles to restructurings, including A/B restructurings.  If principal is deferred beyond a safe harbor period and/or the interest rate is altered, the restructured bonds may be considered “reissued” for tax purposes.  A tax reissuance generally is not overly problematic for financially healthy bonds, as in most cases it merely requires the filing of an IRS tax report (Form 8038) by the issuer, some due diligence by bond counsel and the issuance of a new tax opinion confirming that the reissued bonds are tax-exempt.  In the case of a financially troubled obligor, however, a reissuance has raised vexing questions as to whether the restructured bonds continue to qualify as debt. 

Tax practitioners generally consider a reasonable expectation of full repayment a significant factor in distinguishing a debt investment from an equity investment.  Restructurings that involve a tax reissuance, therefore, present the dilemma of requiring a high degree of confidence as to the repayment of the restructured debt in the face of financial difficulties that are causing the debt to be restructured.  Even if the restructuring involves a mere deferral of scheduled principal payments or resetting of interest outside the reissuance safe harbors, the need to update the repayment expectations as of the reissuance date can be problematic.

Although the expectation of repayment requirement creates tax-exemption opinion issues for a variety of restructurings, it has been of particularly concern in A/B restructurings, where there is almost by definition a reduced expectation of repayment of the “B piece”, which is sometimes referred to as a “hope note” and often represents more a wish than an expectation of repayment.  If bond counsel is uncertain as to whether an instrument is debt at the time it is issued, bond counsel will be unable to give an unqualified opinion that the payments on such instrument constitute interest or tax-exempt interest. In fact, because the A and B pieces are issued simultaneously, in some circumstances a tax-exemption question relating to the B piece may also affect the ability to obtain a tax-exemption opinion on the A piece.

An IRS regulation finalized earlier this year substantially simplifies the tax analysis for  restructurings of tax-exempt debt involving principal deferral or reduction and/or interest resets outside the reissuance safe harbors.  The new regulation also should facilitate A/B restructurings involving tax-exempt bonds.  The regulation amends the § 1.1001-3 tax regulations governing modifications of debt instruments to make the expectation of repayment at the time of a bond restructuring unnecessary provided that expectation existed at the time the bonds were originally issued.  More specifically, the regulation states:

… [I] n making a determination as to whether an instrument resulting from an alteration or modification of a debt instrument will be recharacterized as an instrument … that is not debt, any deterioration in the financial condition of the obligor between the issue date of the debt instrument and the date of the alteration or modification (as it relates to the obligor’s ability to repay the debt instrument) is not taken into account. For example, any decrease in the fair market value of a debt instrument …  between the issue date of the debt instrument and the date of the alteration or modification is not taken into account to the extent that the decrease in fair market value is attributable to the deterioration in the financial condition of the obligor and not to a modification of the terms of the instrument.

The above relief from the debt repayment expectation is not available in cases involving a change in the debt obligor(s).  It also remains the case, as noted in the preamble to the new regulation, that “all relevant factors (for example, creditor rights or subordination) other than any deterioration in the financial condition of the issuer are taken into account in determining whether a modified instrument is properly classified as debt…”  Accordingly, the restructured instrument must promise repayment by some maturity date, even if the repayment schedule is flexible and even if the financial ability of the obligor to make such repayment is questionable as a practical matter (i.e. the failure to repay the bond at maturity must constitute a default and entitle the holder to exercise remedies).  In addition, although subordination is not inconsistent with debt treatment, the reference to subordination as a relevant factor in the regulatory preamble may cause practitioners to look carefully at subordination features in the restructuring context.   So there will still be some tax-related constraints around the structuring of a “B piece.”  However, through this new regulation, the IRS has put an important new tool into the tool box for bondholders of distressed debt by addressing a long-standing problem facing workout practitioners.