Last Thursday, in a state of the commonwealth speech titled "Debts from the Past and Debts to the Future," Puerto Rico's governor pledged to "make it clear to the world that this island pays its bills." Perhaps muddying that message, the governor also promised not to cut public-sector employees' ranks (although he said that he may cut their Christmas bonuses). Earlier in the day, the legislature rejected the governor's tax plan. Further worrying creditors are efforts underway to retroactively amend the Bankruptcy Code to give Puerto Rico a new option for restructuring its debt. The way Puerto Rico handles the debts it incurred in the past will help to determine whether, from whom, and at what price it can borrow in the future.
Investors willingly lend funds to other people's ventures-government or private-when they expect to get paid back according to the initially agreed upon terms. If those terms are legally opaque or might unpredictably change throughout the course of the loan, lenders demand a penalty interest rate or do not lend at all.
To protect themselves, creditors place constraints on the borrower and specify procedures to be followed if the borrower defaults. In hindsight, the borrower may wish that it had not agreed to a particular condition or restructuring procedure. It may decide never to agree to such terms in the future. But adhering to the initial terms of the deal is an important way of signaling that investors should feel confident when handing their money over to the borrower in the future.
Puerto Rican municipal debt, which is tax-exempt all across the United States, has been an attractive option for the individual U.S. investor, mutual funds, and hedge funds over the years. Puerto Rico's warm reception in the municipal markets has been a mixed blessing for the island. According to a 2014 Federal Reserve Bank of New York report, investors' eagerness to lend to Puerto Rico has paved the way to the territory's mounting indebtedness.
In addition to "debt levels [that] are far higher than those of any state and are comparable to those of the most highly indebted countries," the Fed report identified a number of challenges facing Puerto Rico, including "bureaucracy and red tape ... hindering the establishment of new businesses and the growth of existing ones"; large, financially troubled public sector corporations; and weak economic growth.
As Puerto Rico's situation worsens, retail investors are being warned away from these bonds. Other investors, such as mutual funds, are staying away too. S&P, in downgrading Puerto Rican debt last month, remarked that "At present, we believe Puerto Rico has very limited or no external debt market access in either the public or private external debt markets, including investment from private high-risk investors who have provided cash flow financing during the current fiscal year."
The combination of more than $70 billion of debt outstanding, hefty unfunded pension liabilities, a struggling economy, a bloated government, and no clear plans for generating revenue has Puerto Rico and its bondholders dusting off their investment contracts, calling up their lawyers, and taking stock of their options.
In 2014, Puerto Rico passed the Public Corporation Debt Enforcement and Recovery Act to provide Puerto Rican public-sector corporations, such as the heavily indebted power company, new methods for restructuring their debt without full creditor buy-in. In the words of the federal court that heard a challenge of the law, the Act "totally extinguishes significant and numerous obligations, rights, and remedies." According to the court, these obligations, rights, and remedies were established many decades ago in the law authorizing Puerto Rico's power company and the trust agreement governing the bonds the power company issued. The court held that the Act is preempted by the U.S. Bankruptcy Code and is, therefore, unconstitutional.
Following this ruling, the U.S. Congress is considering retroactively amending the Bankruptcy Code to enable Puerto Rico to authorize public-sector borrowers to avail themselves of Chapter 9 restructuring. States already have that authority. Perhaps Puerto Rico should, too. Chapter 9 might have advantages over the existing receivership framework. But retroactive application of the change is troubling because, in effect, it alters the terms of the island's existing deal with creditors.
The Institute of International Finance cautioned against unilateral retroactive changes in its 2014 Report on Implementation of the Principles for Stable Capital Flows and Fair Debt Restructuring because they "may undermine the integrity of financial markets and the sanctity of contracts and should be avoided."
The potential change is a useful warning to investors-particularly retail investors-to think twice before they invest in bonds with terms that are difficult to decipher, likely to change, or likely to be overridden by a change in the applicable legal framework. With Argentina's debt battles and continuing Greek debt woes on the mind, investors are already a bit jumpy.
Efforts to add a new restructuring option to the mix may cast doubt on Puerto Rico's commitment to more substantive efforts to deal with its debt problem, such as shrinking its public sector and unleashing its private sector with regulatory reform.
Retroactive changes to the law may cure creditors of their historically over-eagerness to finance Puerto Rico's public sector, which has not been good for the territory. But such changes also may cause the pendulum to swing too far the other way, as investors shy away from lending in the face of a potentially uncertain and shifting legal framework. If instead, Puerto Rico works out its past debts in accordance with the existing legal framework and pursues sensible fiscal policies, investors will provide the funds it needs to build a healthy future.