Investors in Greek bonds have had no shortage of news covering the country’s debt crisis and the potential fallout of a “Grexit” from the Eurozone. Much less page-space has been devoted to Puerto Rico’s fiscal crisis and the implications if the American territory defaults on its debts, but holders of Puerto Rican municipal bonds are on equally high alert. Due to a confluence of unique circumstances, and absent swift action by Congress, Puerto Rico may soon default and many of the island’s creditors will be on solid footing to reject any restructuring proposals and sue for payment in full.
Similar to Detroit, Puerto Rico was once a manufacturing hub with a solid tax base. Its economic success was due in large part to a provision in the U.S. tax code that exempted profits U.S. companies earned on the island from federal taxes. Pharmaceutical companies in particular flocked: some estimate that at its high point more than half of the drugs sold in the U.S. were manufactured in Puerto Rico. This changed when Congress began phasing out the tax incentive in 1996. It was phased out completely in 2006, and Puerto Rico’s economy has been in free-fall ever since.
After years of insisting that the island would honor its mounting debt obligations in full, Puerto Rico’s governor, Alejandro Garcia Padilla, announced on June 29 that the territory would seek a multi-year moratorium on interest payments, admitting that “the public debt … is unpayable”. “The alternative” he said, “would be a unilateral and unplanned non-payment of obligations”.
Unlike Detroit, Puerto Rico currently has no recourse to Chapter 9 of the U.S. Bankruptcy Code, which allows municipalities of the fifty states and their agencies to restructure their debts in an orderly and uniform fashion. Chapter 9, however, does not apply to U.S. territories. Moreover, because Puerto Rico is not an independent country, it cannot disclaim its debts and devalue its currency.
Last year, Puerto Rico attempted to resolve this impasse by introducing its own analogue to Chapter 9, but bondholders of the Puerto Rico Electric Power Authority successfully challenged the legislation in the U.S. District Court in San Juan. On July 6, the U.S. Court of Appeals for the First Circuit affirmed the District Court’s ruling, holding that Puerto Rico’s legislation was preempted by Section 903(1) of the Bankruptcy Code, and dashing any hope that Puerto Rico might introduce its own municipal insolvency regime without Congressional action. (See Franklin Cal. Tax-Free Trust v. Puerto Rico, Case Nos. 15-1218, 15-1221, 15-1271, 15-1272 (1st Cir. July 6, 2015)).
Further compounding this seemingly intractable situation is the fact that the bonds in question do not contain “collective action clauses,” which are now commonly featured in sovereign debt instruments and would allow a majority of creditors to force (or “cram-down”) a settlement on hold-out creditors. The lack of collective action clauses is particularly problematic for Puerto Rico in light of a well-publicized dispute between Argentina and certain of its bondholders in the wake of the country’s 2001 default and subsequent debt restructuring with its more pliable creditors. In 2012, Judge Thomas P. Griesa of the U.S. District Court for the Southern District of New York enjoined Argentina from servicing its debt to the investors who agreed to the restructuring unless it also paid the hold-out plaintiffs the full face value of their bonds plus all past-due interest, a ruling that was ultimately upheld by the U.S. Court of Appeals for the Second Circuit. (See NML Capital, Ltd. v. The Republic of Argentina, 727 F. 3d 230 (2d Cir. 2013). The U.S. Supreme Court denied Argentina’s petition for a writ of certiorari in June 2014. See Republic of Argentina v. NML Capital, Ltd., 134 S.Ct. 2819 (2014)).
Absent Congressional action to extend bankruptcy protection to Puerto Rico or a federal bailout of the island, it will have limited leverage to force its creditors to the bargaining table for restructuring negotiations. In light of the success Argentina’s hold-out creditors had in court, Puerto Rico’s bondholders may justifiably conclude that litigation will produce a higher return than negotiation.