Puerto Rico bankruptcy pits investors against pensioners

Updated with correction

Puerto Rico's fiscal tug-of-war with pensioners, bondholders, other creditors and its own finances starts a new, uncharted chapter on May 17.

That's when a specially appointed federal judge opens bankruptcy proceedings in a case that dwarfs previous public bankruptcies, with nearly $50 billion in unfunded pension liabilities, $74 billion in bondholder debt and dim financial prospects.

“Puerto Rico faces a nearly existential financial shortfall,” its oversight board said in a recent report, with the government making commitments to employees, pensioners, enrollees in health-care programs, bondholders and others “that cannot be met based on a realistic measure of the tax revenues the economy can currently support.”

U.S. District Judge Laura Taylor Swain of the Southern District of New York, appointed by U.S. Chief Justice John Roberts, has a delicate balancing act ahead. She must weigh giving the commonwealth a chance to reform decades of declining revenues and irresponsible spending while also winning deep discounts from bondholders that won't scare off potential investors. Too-severe cuts to pensions and public services could also prompt more citizens to pull up stakes.

Ms. Swain will have scores of claims to oversee, including those from major mutual fund and hedge fund investors holding general obligation bonds already in default, COFINA bonds backed by sales tax revenues, and bonds issued by the Puerto Rico Electric Power Authority, PREPA, among other agencies. She also will have to settle plenty of disputes over who gets priority — pensioners, creditors or Puerto Rico's treasury.

And the lawsuits keep coming, including a new one filed May 2 in San Juan by funds run by Whitebox Advisors LLC, Merced Partners LP, Tilden Park Capital Management LP and others holding $1.9 billion of senior COFINA bonds. Those bondholders argue Gov. Ricardo Rossello's fiscal plan diverting payments to government coffers violates U.S. and Puerto Rico constitutions.

Another group of hedge fund investors in general obligation bonds, including Aurelius Capital Management LP and Monarch Alternative Capital LP, also sued in New York on May 2.

The foundation for court restructuring of the commonwealth's obligations was laid by the Puerto Rico Oversight, Management and Economic Stability Act, whose Title 3 allows for restructuring.

The federal law, approved by Congress June 30, 2016, also created the oversight board and gave it the power to approve Puerto Rico's fiscal plan. That plan, as amended by the board to make deeper cuts, is expected to be finalized by June 30.

For investors, the fiscal plan calls for creditors to get nearly $800 million per year, an 80% cut from the amount previous governors had committed to debt service.

For the three main pension plans expected to run out of money this fiscal year, the plan calls for a 10% cut in pension outlays based on income, with no cuts for people below the poverty line, and switching all active members and new hires into defined contribution plans. Existing pension obligations will be met on a pay-as-you-go basis, liquidating assets and using general fund revenues.

The plan also calls for deeper 30% government worker health care cuts, and other fiscal austerity measures.

For some debt holders, the court process comes as a relief, after losing patience with what the major COFINA bondholder group of mutual funds led by Franklin Resources Inc., OppenheimerFunds and Banco Santander, called “take-it-or-leave-it” offers from the government during attempted negotiations.

Mr. Rossello acknowledged in a May 3 statement insufficient progress in those negotiations, and said the court process will allow Puerto Rico to restructure its debt “to a sustainable level,” but noted his priority is the Puerto Rican people.

PREPA bondholders are in better shape, with a proposed settlement agreement announced April 6 that restructures $9 billion in debt by offering them 85 cents on the dollar, and giving PREPA more time to begin making payments. The agreement is the only deal struck so far since Mr. Rossello became governor, and must be approved by the oversight board.

Bond experts say that the very features that made Puerto Rico debt so attractive — exemptions from federal, state and local taxes for any U.S. resident, and significantly higher yields than high-quality municipal bonds — should have been a warning sign.

“There was a lot of debt being issued while Puerto Rico was beginning to exhibit serious problems,” said Tom Schuette, partner and co-head of investment research and strategy for Gurtin Municipal Bond Management, San Diego, which manages $12.3 billion. “It was kind of a shell game or a Ponzi scheme. No one in Puerto Rico had any money, and the market aided and abetted them.”

Many state-specific mutual funds loaded up on Puerto Rico debt to boost returns, Mr. Schuette said.

After mutual funds and other investors got spooked by Puerto Rico's sustained recession and unaddressed budget shortfalls, and prices started falling, hedge funds jumped in. It didn't help investors that many of Puerto Rico's securities held investment-grade ratings up until a few years ago, and investors didn't realize that Puerto Rico's pension funds were so poorly funded, Gurtin warned in 2014.

Creditors are expected to press the court on whether it favors pensioners over creditors, and whether there is enough shared sacrifice by Puerto Rico residents. Creditors could also seek a share of future benefit payments.

Another issue raised by the oversight board is mismanagement of the pension funds, including the Puerto Rico Employees' Retirement System, Hato Rey, whose latest financial statement released in 2016 by KPMG showed assets of $3.4 billion and a funded ratio of 0.27%, as of June 30, 2014.

Oversight board officials turned to the federal Thrift Savings Plan, Washington, as a model for the type of defined contribution plan they are recommending for Puerto Rico public employees going forward. Management of the recommended 401(k) plan is likely to be outsourced.

It will be expensive for the government in the short term to implement the plan and start contributions, but it does help officials and participants know what to expect going forward.

The odds are stacked against Puerto Rico, said Frank Shafroth, director of the Center for State and Local Government Leadership at George Mason University in Fairfax, Va., because Congress failed to provide the PROMESA board fiscal stimulus tools or address unfair competition from other Caribbean nations.

That could continue a brain drain out of Puerto Rico and push the economy toward a tipping point, said Mr. Shafroth, whose great-grandfather sponsored the 1917 law that created Puerto Rico's commonwealth status and helped make Puerto Rican bonds so attractive. Now, he said, “I suspect my great grandfather would be ashamed at Congress' and the Treasury's inattention.”