Understanding Puerto Rico’s Bankruptcy Crisis
In August 2015, Puerto Rico became the first territory in U.S. history to default on its debt. As of January 2016, it had amassed $115 billion in combined bond debt and unfunded pension liabilities that it cannot pay. The Supreme Court of the United States is currently reviewing whether federal bankruptcy law prohibits Puerto Rico, as a territory, from passing legislation to assist its public utility companies in restructuring their bond debt. We explain the legal and financial issues at stake for Puerto Ricans and their creditors.
Chapter 9 Bankruptcy Law and Puerto Rico’s Status as Territory
Chapter 9 is a provision of United States federal bankruptcy law that governs how municipalities (such as cities, counties, and municipal utilities) can declare and resolve bankruptcy. Chapter 9 requires states to approve municipalities’ filings for bankruptcy, and also bars states from passing their own legislation to restructure their or their municipalities’ debt without creditors’ consent.
In 1984, the United States Congress barred Puerto Rico from authorizing its municipalities to declare Chapter 9 bankruptcy due to its legal status as a territory. However, Puerto Rico may still be subject to the Chapter 9 restriction that bars states from restructuring debt with local legislation without creditors’ approval.
The Recovery Act in Question
By June 2013, Puerto Rico’s three main public utility companies had amassed over $20 billion in combined bond debt. Because its public utility companies are barred from Chapter 9 protections, Puerto Rico crafted the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the “Recovery Act”) to allow its public utility companies to restructure their debt.
The companies’ creditors sued, arguing that the Recovery Act violates the provision of Chapter 9 that prohibits states from passing debt restructuring legislation. The United States Federal District Court and Court of Appeals for the First Circuit both ruled in favor of the creditors. Puerto Rico appealed to the United States Supreme Court in September 2015 and presented its case on March 22, 2016. The Supreme Court is expected to issue its ruling in June 2016.
Questions Facing the Supreme Court
The major issue facing the Supreme Court is whether the provision of Chapter 9 that prohibits states from passing local debt restructuring legislation, such as the Recovery Act, also applies to U.S. territories. The Court’s decision will determine whether the island can pass restructuring legislation that allows its insolvent public utility companies to reorganize over $20 billion in current bond debt.
Puerto Rico’s Prospects for Legal Protection
The Recovery Act only applies to Puerto Rico’s three main public utility companies and their creditors. As a result, it only provides restructuring solutions for $20 billion of Puerto Rico’s $72.2 billion in bond debt. Regardless of whether the Supreme Court upholds or invalidates the Recovery Act, Puerto Rico will still need to address its remaining $52 billion of debt.
If the Supreme Court upholds the Recovery Act, it would create legal precedent enabling Puerto Rico to pass debt restructuring legislation for its municipalities more generally. Puerto Rico then could pass restructuring legislation that addresses other creditors and components of its public bond debt not included in the Recovery Act.
If the Supreme Court denies Puerto Rico’s appeal, Puerto Rico would have little to no legal recourse under U.S. law for resolving its financial crisis. The island’s public utility companies would remain barred from declaring bankruptcy and receiving protections under Chapter 9 and Puerto Rico would be barred from passing legislation to help them.
However, the Supreme Court ruling is just one possible avenue for addressing Puerto Rico’s outstanding bond debt. Legislative action by the U.S. Congress may also provide debt relief to the island. As of March 2016, both the U.S. House and Senate are reviewing pending legislation that would provide Puerto Rico with Chapter 9 protections and/or debt restructuring options. Any legislation passed by Congress would supersede a Supreme Court’s ruling against Puerto Rico.
Understanding Puerto Rico’s Path to Fiscal Insolvency: Amassing Debt to Service Debt
Overview of Puerto Rico’s Debts and Liabilities
In 2014, Puerto Rico’s total public long-term liabilities amounted to $115.7 billion, and consisted of two major types of liabilities:
- Bond debt accounts for $72.2 billion, or over 62%. This debt has resulted from years of economic decline and extensive borrowing via bonds to fund government expenses.
- Unfunded pension liabilities across Puerto Rico’s three pension systems amount to a combined $44 billion, or 38% of Puerto Rico’s long-term liabilities. As of June 2014,
- The Employees’ Retirement System of the Government of the Commonwealth of Puerto Rico (ERS) had $30.0 billion in unfunded liabilities.
- The Commonwealth of Puerto Rico Judiciary Retirement System (JRS) had $442.5 million in unfunded liabilities.
- The Puerto Rico System of Annuities and Pensions for Teachers (TRS) had $13.1 billion in unfunded liabilities.
According to the most recent audited financial documents (Fiscal Year 2013), Puerto Rico’s pension systems (Employment Retirement System, Judicial Retirement System, and Teachers Retirement System) could be completely depleted “by fiscal years 2015, 2019, and 2020, respectively.”
Borrowing via Bonds in Low Revenue Years
Puerto Rico has a long history of funding government services by issuing general obligation municipal bonds. These bonds were particularly attractive for buyers because of their security; Puerto Rico’s constitution requires general obligation bonds to be prioritized and paid before other government expenses. During the 2008 financial crisis, Puerto Rico’s revenue decreased and its Gross National Product declined sharply. Puerto Rico faced further challenges funding government services and responded by issuing even more bonds to obtain the necessary revenue.
Using Pension Funds to Service Debt
As Puerto Rico’s debts increased, the government transferred funds from one government agency to another. Exacerbating the unfunded pension liability, officials used the limited funds from Puerto Rico’s three pension systems to fund both debt service and government expenses. By May 2015, Puerto Rico’s retirement system was only funded at less than a penny to the dollar.
- Puerto Rico’s total public debt and unfunded pension liabilities amount to $115.7 billion, including $72 billion in general obligation bond debt and $44 billion in unfunded pension liabilities.
- A long history of borrowing to service outstanding debt and a shrinking economy has worsened Puerto Rico’s fiscal position.
- In 2014, Puerto Rico passed the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the “Recovery Act”) to provide three of its public utility companies with options to restructure over $20 billion in debt.
- The public utility companies’ creditors sued, arguing that the Recovery Act violates the provision of Chapter 9 that prohibits states from passing their own debt restructuring legislation.
- Puerto Rico’s status as a territory creates legal uncertainty because there is no precedent to determine how Chapter 9 applies to territories. In June 2016, the Supreme Court will determine whether Puerto Rico’s Recovery Act violates Chapter 9 and whether the island can pass its own restructuring legislation to allow its insolvent public utility companies to restructure their debt.
*A previous version of Figure 1 mistakenly switched the Teachers Retirement System and Judicial Retirement System labels. The accompanying text correctly characterized the Teachers Retirement System liability at $13.1 billion; and Judicial Retirement System liability at $0.4 billion. The figure was updated at 1:30pm on May 2, 2016.
PUERTO RICO TIMELINE
1984: U.S. Congress rules that Puerto Rico cannot authorize its municipalities to declare bankruptcy under Chapter 9 because of its status as a territory. Congress argues that Chapter 9 only allows states to authorize bankruptcy.
2006 – Present: Puerto Rico’s economy has contracted by more than 10%. Poverty levels are high; employment levels are low; and tax revenues are shrinking as growing numbers of Puerto Ricans are either leaving the island or are of retirement age.
2008: Puerto Rico is hard hit by the recession. Revenues further decrease and debt grows as the island issues more bonds to pay for government expenses.
2012: Moody’s Investor Services began researching Puerto Rico’s use of bonds and found that $850 million of $1.1 billion in bonds bought in 2011 were solely used for debt service and budget holes.
2013: Puerto Rico was barred from the traditional municipal bond market.
February 2014: All three rating agencies (Moody’s Investors Services, Standard and Poor, and Fitch Ratings) downgraded Puerto Rico’s debt rating.
June 2014: Puerto Rico passed the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the “Recovery Act”), which outlined two options for three of the island’s insolvent public utility companies to restructure its debt.
July 2014: Moody’s Investors Services downgraded Puerto Rico’s bond ratings again, stating that the Recovery Act signaled Puerto Rico’s inability to support its debt.
February 2015: The public utility company’s creditors sue, challenging the validity of the Recovery Act under Chapter 9. The District Court rules in favor of the creditors, preventing Puerto Rico’s insolvent public utility companies from restructuring their debt.
August 2015: Puerto Rico appeals the lower courts’ decisions to the Supreme Court.
December 2015: Puerto Rico’s appeal to the Supreme Court is granted.
January 2016: Puerto Rico defaults for the second time on debt payments after failing to pay $35.9 million and $1.4 million in bond payments owed by Puerto Rico Infrastructure Financing Authority and the Public Finance Corporation, respectively.
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