The challenges, vulnerabilities, and potential repercussions exposed by recent court decisions in the lawsuits between Puerto Rico and its creditors were examined by some of the country’s leading experts in laws covering municipal bonds at the AFGI Puerto Rico Bankruptcy Risk Summit in New York.

Panelists explored the legal framework around two recent decisions —and raised significant concerns about the rulings. 


In February, U.S. District Court Judge Laura Taylor Swain, who is overseeing Puerto Rico’s 2017 bankruptcy filing, issued an order approving the restructuring of approximately $17 billion of sales-tax-backed debt in the case regarding Puerto Rico’s Sales Tax Financing Corporation, known as COFINA.

Recovery was reached by giving senior bondholders 93% of their original investment, and holders of subordinate debt 56%. The U.S. commonwealth seeks to restructure about $72 billion of its pension obligations.

“It was challenged on many fronts in Puerto Rico,” said panel moderator David Dubrow, a partner at Arent Fox, a Washington, D.C. law firm. Dubrow specializes in bankruptcies and represents financial institutions that make loans to finance real estate projects and provide credit and liquidity facilities for tax-exempt bond issues.

“If there had not been subordinate bonds, things would have been different for senior bonds” Dubrow added. “Which points to vulnerabilities in the securitization structure that led to this result.”

In February, COFINA conducted a forced exchange of $17 billion of outstanding sales-tax bonds, delivering $10 billion of new COFINA bonds. The court ruled that future sales tax revenue previously pledged exclusively to COFINA will be split, with 53.65% going to COFINA bondholders and the commonwealth government receiving 46.35%.

Kevin Roche, a partner at San Francisco law firm Orrick, with expertise in various general obligation and revenue bond financings, said the COFINA decision has forced market participants to acknowledge the stress between sales-tax securitization and general obligation debt, and requires participants to identify the vulnerabilities and solve for them.

With COFINA, the central question of whether or not the pledged sales tax belonged to COFINA, and not the Commonwealth, had never been adjudicated, said Roche.  The order of the court approving the new COFINA bonds essentially served as a validation proceeding, that in fact the pledged sales tax does belong to COFINA, he added.

Roche specified three ways to solve for those vulnerabilities: Use validation proceedings, where they are available, to shore up securities; make sure statutory liens are drafted properly; and use bankruptcy structures that can be replicated around the country.

“You need to have a statute that specifically says it’s a true sale,” asserted James Spiotto, managing director at Chicago-based Chapman Strategic Advisors, the consulting subsidiary of Chapman and Cutler LLP. “Bankruptcy securitizations live and die on whether or not it’s a true sale.

“You need a statute that makes sure the specific promises and pledges are irrevocable,” Spiotto added. “Because in bankruptcy, someone can go into the courts and say, ‘I said that then, but now I’m in bankruptcy with hardship, and we need to do it this way.’ If securitizations are to continue to grow, there should be specific state statutes.”

Special Revenue Bonds

On March 28, 2019, affirming a ruling by Judge Swain in early 2018, the Boston-based U.S. First Circuit Court ruled that municipalities are not required to make payments on debt secured by special revenues while bankruptcy proceedings are ongoing. However, municipalities can voluntarily opt to make the payments.

“This was a significant decision by a circuit court,” said Dubrow. “So the question we want to pose is, ‘what impact will this decision have on revenue bond issuances? Are there changes in the structuring of transactions that may address this decision and are there any other steps that could be taken to address its impact?”

“Disclosure practice has changed, but it’s hard to isolate the impact of Puerto Rico or Detroit’s bankruptcy,” said Jeffrey Aronoff, a principal at Detroit law firm Miller Canfield. “Clearly, there is some. But bear in mind this was taking place in an environment where disclosure was already changing.”

However, “from a disclosure standpoint, it’s pretty hard to start the disclosure saying the court was wrong,” asserted Spiotto. “There’s a cloud here. This decision is contrary to Jefferson County (Chapter 9 case ruling) and contrary to what the 1988 Amendments (to the Federal Bankruptcy Code) were about.”

“It cries out that it needs a resolution,” said Spiotto. “Either a reversal or something else that will help clarify and dispel the cloud.”

In effect, the court said the municipality can pay voluntarily, but it’s not mandatory.

“That’s nice, but in the land of municipal bonds, there are a lot of things that are mandatory and very few that are voluntary,” Spiotto added. “The statute says the unlimited tax general obligation collection that came into the Territory’s treasury was to pay it over to a special account for the bondholders or bond trustee. It wasn’t a ‘could,’ ‘would,’ or ‘would you like to?’ It was a “shall.’”

“The decision is clearly wrong”

“I think the decision is clearly wrong because you’re going to run afoul of a lot of states’ statutes,” said Spiotto. “What would be very helpful is looking at the bankruptcy code and the case law in Jefferson County, and creating a model state statute that would clarify the disclosure issues and use the power of the First Circuit decision, using their statement that the court doesn’t have power to interfere with the revenues of municipalities. And also the provision in the bankruptcy code that it can’t be interpreted to limit or impair the power of the state to control municipalities exercising its power, which includes expenditures and special revenue payments.”

As Dubrow concluded, “what this decision does is it creates more uncertainty in the marketplace. And people will have to deal with that.”