Puerto Rico
Oversight Board, UCC Seek to Nullify More Than $6B in GO Bonds Citing Constitutional Debt Limit
Tue 01/15/2019 06:10 AM
Relevant Documents:
Claim Objection
Press Release
Procedures Motion
The PROMESA oversight board’s special claims committee and the official committee of unsecured creditors in the Title III cases filed a joint objection on Monday evening, Jan. 14, seeking the disallowance of more than $6 billion of claims based on commonwealth general obligation bonds issued in or after March 2012.
In challenging more than $6 billion of GO bonds as “invalid,” the objection focuses on bondholders and monoline insurers that have filed proofs of claim that include the allegedly invalid GO bond claims of $50 million or more against the commonwealth. The claimants, which are identified in Appendix I to the objection, are ASM BLMIS Claims LLC; Assured Guaranty Municipal Corp.; Aurelius Investment LLC; Aurelius Opportunities Fund LLC; Autonomy Master Fund Ltd.; Brigade Capital Management LP; FPA Crescent Fund; LS Strategic Income Fund; Mason Capital Master Fund LP; and Prisma SPC Holdings Ltd. Segregated Portfolio AG. The filing includes a chart summarizing the information regarding each claimant, which is excerpted below:
Regarding the scope of the objection, the objectors include the following explanatory footnote:
According to the objection, of the $13 billion in outstanding GO bonds, “$6 billion of those GO bonds are invalid and that no claims based on those bonds are allowable against the Commonwealth.” The objectors contend that such debt is invalid because, among other things, it was issued in violation of the Puerto Rico Constitution’s debt service limit “when properly calculated” to include debt service on bonds issued by the Puerto Rico Public Buildings Authority, or PBA. In arguing that PBA bonds should be included in the calculation of the debt service limit, the objecting parties assert that the PBA structure is “a sham.” The filing contends that the commonwealth’s 2014 GO bonds “are invalid even without including debt service on PBA bonds.” The claim objection alternatively requests that to the extent such claims include unamortized original discount, such claims should be disallowed.
The objection further argues that the GO bonds are invalid because they were also issued in violation of Puerto Rico’s constitutional balanced budget clause. According to the objection, if approximately $425 million of interest that was excluded was included, “the issuance of the 2014 GO Bonds would have been shown to violate the Debt Service Limit (even without including debt service on the PBA Bonds)” (emphasis added). The board and UCC attach as Appendix II to their objection two versions of the debt limit calculation: one in which they exclude the $422.7 million of interest, concluding that the constitutional debt limit was not exceeded, and one in which they include that interest, concluding that the constitutional debt limit was exceeded.
Separately, the UCC also alleges that the debt violates the balanced budget requirement in Article VI, section 7 of the Puerto Rico Constitution, because proceeds of the debt were used to finance deficit spending.
The movants filed the declaration of James Bliss of Paul Hastings LLP, co-counsel to the UCC, which attaches copies of various documents relating to the claim objection, and Bliss also submitted an additional declaration indicating that the movants are not able to determine at this time whether any of the claimants subject to the claims objection are in military service.
Separately, the oversight board and the UCC filed a motion to establish procedures for the resolution of their claims objection, described below. The movants also filed a request expedited consideration of the procedures motion, proposing the following dates:
The EMMA links to the GO bond issues identified as “invalid” in the objection are below:
The oversight board said in the press release that it is “mindful of the extraordinary responsibility” it has been given under PROMESA and has the duty to act in the best interests of Puerto Rico and all of its creditors as the representatives of Puerto Rico in the Title III restructuring. “Challenging improperly issued debt is consistent with that duty,” the oversight board said.
According to the press release, the special claims committee described the investigation as “an integral part of the Board’s mission to restore fiscal balance and economic opportunity and to promote Puerto Rico’s reentry into the capital markets.”
The UCC is represented by Paul Hastings LLP as counsel and Zolfo Cooper LLC as its financial advisor. The special claims committee is represented by Brown Rudnick.
Claim Objection
The objectors explain that the issues raised in the filing are “gating issues” for the commonwealth’s plan of adjustment process. “From the outset, holders of GO bonds have claimed entitlement to a so-called ‘constitutional priority of payment’ such that, in their view, no other unsecured creditor of the Commonwealth can receive a single penny of plan distribution until all GO bondholders have been paid in full,” according to the filing. The special claims committee and the UCC note, however, that for a “number of reasons beyond the scope of this Objection,” they, along with numerous commonwealth creditors that include retirees and essential service providers, “do not agree that the GO bondholders are entitled to such a priority.”
“Nevertheless, whether more than $6 billion of GO bondholder claims should be disallowed is unquestionably a critical gating issue,” says the objection.
Before turning to the substance of the claim objection, the special claims committee and the UCC also include the following reservation of rights:
After reviewing the constitutional debt service limit and the constitutional balanced budget clause, the claim objection provides an overview of the commonwealth GO bonds, including the issuances that the objectors argue are invalid, and the PBA bonds.
The objectors begin by arguing that the allegedly invalid GO bonds were issued in violation of the constitutional debt service limit under the Puerto Rico Constitution. As previewed above, the objection explains that “[t]he Debt Service Limit in Article VI, Section 2 of the Commonwealth Constitution limits the amount of debt the Commonwealth can issue by limiting the amount of future debt service the Commonwealth can take on relative to its past internal revenues.” The objectors note that new debt “cannot be issued if, when added to any payments by the Commonwealth in the prior fiscal year on account of debt guaranties, debt service on direct, full faith and credit obligations of the Commonwealth would exceed (in the current or any future fiscal year) 15% of the Commonwealth’s average internal revenues for the prior two fiscal years.”
As an initial matter, the objectors maintain that the allegedly invalid GO bonds were issued “in violation of the Debt Service Limit when properly calculated to include debt service on the PBA Bonds.” The objection contends that there can be “no dispute that, if debt service on the PBA Bonds is included in the calculation, the Debt Service Limit was first exceeded with the issuance of the Series 2012 B GO Bonds on March 29, 2012.” The filing charges that the commonwealth's average internal revenues for the two fiscal years prior to 2012 - 2010 and 2011 - “was $7.6004 billion.” According to the objectors, with the issuance of the 2012 B GO bonds, “the maximum debt service in any fiscal year (including PBA Bond debt service) was $1.2291 billion in 2020 (inclusive of $16.5 million of Commonwealth guaranteed debt payments made in fiscal year 2011), which is more than 15% (16.2% to be precise) of the Commonwealth’s average internal revenues for the prior two fiscal years” (emphasis added). Therefore, according to the claim objection, the commonwealth “proceeded to issue another $5.8 billion in GO bonds over the next two years, all of which also violated the Debt Service Limit.”
In arguing that PBA bonds must be counted toward the constitutional debt limit, the objection alludes to an adversary complaint filed by the oversight board and the UCC last month seeking a declaratory judgment that the PBA leases "are not 'true leases,' but, rather, disguised financing transactions."
Last night’s filing says: “Courts throughout the country have seen such public building authority structures for what they really are - transparent shams designed to circumvent constitutional debt limits. In the words of one such court, public building authority structures are “a scheme which would fool only a lawyer.”
The claim objection acknowledges that, in form, the PBA bonds “are not ‘direct obligations’ of the Commonwealth subject to the Debt Service Limit.” “In economic substance, however, they are exactly that.” The objection argues that the PBA structure “serves no other purpose than to finance the construction and improvement of buildings for the Commonwealth through the issuance of debt that, while not in the Commonwealth’s name, is payable (directly or indirectly) from the Commonwealth’s general revenues and depends solely on the Commonwealth’s credit.” According to the special claims committee and the UCC, the official statements for the PBA bonds “give away the game, as nearly all of the disclosure in the Official Statements is focused on the creditworthiness and activities of the Commonwealth, not the PBA.”
The objectors provide an overview of public building authorities created by other governmental entities. “From the beginning, public building authorities have had but one purpose - the circumvention of constitutional debt limits,” says the objection. While the PBA structure “differs in certain details from the traditional structure,” the objection maintains that the PBA “is no less a sham - in fact, it is more so.” According to the objection:
The objection then reviews a series of state court rulings on public building authorities, asserting that “[s]ince the advent of public building authorities as a debt limit evasion device, courts in various jurisdictions have refused to countenance such a transparent artifice.” The filing also reviews certain decisions by the U.S. Bankruptcy Court for the District of Puerto Rico regarding true leases. In addition, the objection notes Detroit’s challenge to the certificates of participation, or COPs, structure as part of the chapter 9 case and draws comparisons between the COPs structure and the PBA, while acknowledging that the COPs structure was not a public building authority.
The objectors also contend, however, that the PBA structure in Puerto Rico “appears to be unique in that the Commonwealth explicitly ‘pledged’ its full faith and credit, not only to guarantee the rents payable by Commonwealth entities, but to guarantee the PBA Bonds themselves” (emphasis added). According to the filing, even if the commonwealth “had not explicitly guaranteed the bonds, it did so implicitly by guaranteeing the rents, which are the source of payment for the debt service.” Therefore, says the objection, the calculation of the debt service limit “must include” the PBA bond debt service (as opposed to guaranty payments made on account of PBA bonds) “because, in economic reality, PBA debt service is a direct obligation of the Commonwealth.”
However, even if PBA bond debt service is not included in the calculation, the objectors argue that the 2014 GO bonds “were issued in violation of the Debt Service Limit when properly calculated to include interest on the 2014 GO Bonds payable from the proceeds of the 2014 GO Bonds themselves.” According to the claim objection, while the 2014 GO bonds were issued in the aggregate principal amount of $3.5 billion, almost $425 million of the 2014 GO Bond proceeds “were used to pay interest on the 2014 GO Bonds during the first three years they were outstanding, and those interest payments were excluded from the calculation of the Commonwealth’s Debt Service Limit.” As a result, says the filing, the commonwealth “really borrowed approximately $3.1 billion for the intended purposes but, because the Commonwealth knew it would not have sufficient revenues to pay even the first few years of interest on the bonds, it borrowed money for that too” (emphasis added).
The plain language of the constitutional debt service limit calculation “does not depend on the source of payment for the debt service,” say the objectors, who argue that, as a result, the interest paid from the proceeds of the 2014 GO bonds “was ‘interest on such bonds’ just the same as interest on the bonds paid from any other source.” The objection explains that in calculating the debt service limit, “the Commonwealth did not include the nearly $425 million of interest to be paid from the proceeds of the 2014 GO Bonds themselves in fiscal years 2014, 2015, and 2016, thereby creating the appearance that the Debt Service Limit would not be violated.” The objectors reference Appendix II to the filing, which they say demonstrates that the issuance of the 2014 GO bonds would have been shown to violate the debt service limit (even without including debt service on the PBA bonds) had that interest been included in the calculation. The filing also points out that “the proceeds used to pay interest were not even held in a separate escrow account for that purpose.”
According to the objection, general obligation bonds “are traditionally issued to finance capital projects such as land acquisition and infrastructure development.” By contrast, the objection contends, the “Invalid GO Bonds were used (among other purposes) to finance deficit spending (directly or indirectly), which is not a purpose for which the Commonwealth had the power to borrow money.” Further, the filing says, the 2014 GO bonds were issued when the commonwealth was “already straining under an unsustainable debt load and had already engaged bankruptcy counsel to draft debt restructuring legislation” that was ultimately struck down by the Supreme Court.
The objection filed by the special claims committee and UCC continues, asserting that the English version of the Commonwealth Constitution provides that “[t]he appropriations made for any fiscal year shall not exceed the total revenues, including available surplus, estimated for said fiscal year unless the imposition of taxes sufficient to cover said appropriations is provided by law.” The Spanish version of the Constitution uses the term recursos totales, according to the objection, which in English means “total resources,” not “total revenues.” The question was taken up by the president of the drafting committee, who explained that recursos totales was meant to be broader than “total revenues,” which was the term used in the balanced budget clause of the Jones Act, which governed Puerto Rico until the adoption of the Commonwealth Constitution. The objection adds: “He further explained that ‘recursos totales’ was meant to include, among other things beyond tax revenues, the ‘issuance of bonds’ (translated from Spanish).”
While the Spanish version of the Constitution uses a term “that is broader than ‘total revenues’ and was meant to include some form of bond proceeds,” the board and UCC argue that the English version uses “total revenues” just like the Jones Act. According to the objection, because “revenues” does not include borrowings, “the constitutionality of deficit financing depends, as an initial matter, on which version of the Constitution controls.”
The objection continues, arguing that there can be “no doubt that it was the English version of the Constitution that the U.S. Congress approved.” As a consequence, the objection asserts, the “terms” in accordance with which the Constitution became effective “were the terms of the English version approved by the U.S. Congress; not the Spanish version debated at the constitutional convention.” The oversight board and UCC argue that it is “indisputable that, if the English version controls, deficit financing is constitutionally prohibited and, because they were used to finance deficit spending, the Invalid GO Bonds were not issued for a lawful purpose.”
In addition, the objection asserts that the invalid GO bonds are rendered "null and void" because they were issued in violation of the debt service limit and the balanced budget clause and, "as a consequence, the bondholders have no remedy." Citing Article VI, Section 9 of the Commonwealth Constitution, the objectors argue that when a government transaction violates Puerto Rico law, "a private counterparty has no remedy if the illegality implicates a clear public policy."
“The Debt Service Limit and the Balanced Budget Clause inarguably embody a clear public policy of the Commonwealth regarding the issuance of debt, and thus holders of the Invalid GO Bonds cannot recover under an unjust enrichment theory,” the objection states, citing several Puerto Rico Supreme Court cases.
The objection states that relevant case law demonstrates that equitable theories such as estoppel, unjust enrichment and ratification “are of no avail” and that the Puerto Rico Supreme Court has “‘unequivocally rejected’” the application of equitable estoppel as developed in the common law for use in its civil law system. The objectors also maintain that a similar doctrine known as “actos propios,” or the “doctrine of one’s own acts,” allows a court to apply equitable principles in the absence of any applicable law system via Article 7 of the Puerto Rico Civil Code. The doctrine applies to government action only "where the public interest would otherwise be harmed," and courts will not apply the doctrine if doing so would violate law or public policy, according to the objection. It also asserts that a fundamental commonwealth public policy expressed in its Constitution is that "the power of the Legislative Assembly to incur debt should be limited based on the Commonwealth’s internal revenues, lest political expediency lead to the accumulation of an unsustainable debt burden."
The objectors also assert that the doctrine of unjust enrichment cannot be applied in contravention of a clear public policy embodied in a statute or the Constitution. The same is true of ratification, says the objection, which also contends that under Puerto Rico law, if a government contract does not follow strict formation requirements and comply with all applicable laws, it is of no force or effect and cannot be ratified by later conduct.
"In short, a private party transacting with the Commonwealth takes the risk that, if the transaction runs afoul of a clear public policy embodied in a statute or the Constitution, no remedy will be available against the Commonwealth. Although a harsh result for the counterparty to an unlawful transaction, allowing a recovery against the Commonwealth (in whatever form) would be a much harsher result for the people of Puerto Rico as a whole. Laws governing the expenditure of public funds exist for one reason - to protect the interests of Puerto Rico taxpayers," the objection states.
The objection then turns to the GO bondholders’ potential defenses under Puerto Rico’s UCC Article 8, specifically section 8-202 (providing for the validation of securities under specified conditions as a defense to an issuer’s assertion of invalidity, according to the objection) and section 8-210 (providing a remedy to holders of “overissued” securities, according to the objection). The objectors argue that neither provision “gives rise to an allowable claim against the Commonwealth.”
First, the objection argues that “no statute can nullify the Constitution.” Citing a case from the Florida Supreme Court, the objection asserts that although a statute may “validate bonds originally issued without authority, provided the Legislature could have authorized the issuance of the bonds in the first place,” but such a statute cannot remedy a situation where “bonds are issued in violation of a mandatory provision of the Constitution.” In the later instance, says the Florida Supreme Court “such bonds are void ab initio, and cannot be validated by curative legislation.”
Next, the objection looks to the text of Puerto Rico’s UCC Article 8 and related statutes, including their remedy provisions and concludes:
The filing adds that section 8-202 is inapplicable for other reasons, including that this provision applies “only to claims of invalidity by the ‘issuer’ of the defective securities, and neither Objector was the ‘issuer’ of the Invalid GO Bonds within the meaning of the statute.” In addition, say the objectors, “deficit financing was not a purpose for which the Commonwealth had the power to borrow money” and “any bondholder invoking UCC 8- 202 has the burden of establishing such bondholder’s eligibility for validation.” The objection concludes this section by asserting that if a bondholder is an original issue purchaser, “section 8-202 is inapplicable on its face.”
The objection notes that most of the Invalid GO Bonds were issued with OID, citing the 2014 GO Bonds, which were issued at OID of 7%, or 93% of par. It asserts that Section 502(b)(2) of the Bankruptcy Code bars the recovery of “unmatured interest” and that bankruptcy courts have unanimously held that “unmatured interest” includes unamortized OID. The exclusion of original issue discount is to prevent creditors from claiming "disguised, unearned interest," according the objection.
The objectors state that "to the extent that OID on Invalid GO Bonds remained unamortized as of the Petition Date, the portion of any claims constituting such OID must be disallowed. The Objectors will establish at trial that, as of the Petition Date, more than $230 million of OID on Invalid GO Bonds remained unamortized."
Procedures Motion
The objectors separately moved for an order: (i) permitting the omnibus objection to the claimants listed in the chart above and the claims of those holders who elect to participate in the litigation, “even if the ultimate number of Challenged GO Bond Claims exceed one hundred”; (ii) establishing procedures for providing notice of and an opportunity to participate in the litigation to other parties in interest, including the AAFAF and the official retiree committee, and to all “actual and potential holders” of the challenged GO bond claims, “including those that have not filed claims or otherwise appeared in these Title III cases”; and (iii) establishing certain initial litigation procedures for all participants.
The objectors note that over 4,000 bond claims have been filed in the case and “unlike in the private debt issuance context, no indenture trustee exists that may serve as a representative for all holders of Challenged GO Bonds in these cases.” Given this, the objectors propose “litigation of the Objection and defenses thereto as part of one organized process as opposed to requiring Objectors to pursue their objections in strict compliance with Bankruptcy Rule 3007.” More specifically, the procedures propose to joint briefing, discovery and argument on the issue of “whether the Commonwealth issued the bonds in violation of the constitutional debt limit and/or the balanced budget clause of the Commonwealth Constitution.”
As for notice to potential GO bond claimants who have not filed claims or appeared in the case, the motion proposes notice be provided in newspapers and on the EMMA website and would order Cede and the Depository Trust Co., or DTC, to assist in the noticing process. Specifically, the procedures propose that an “objection notice” be distributed by CEDE and DTC. The notice would also be published in (a) El Nuevo Dia; (b) Caribbean Business; (c) El Diario and El Nuevo Herald; (d) The Bond Buyer; and (e) on the municipal bond website EMMA.
The objection notice would outline procedures for participating in the case. Under the procedures, parties that wish to participate in the litigation process would have 30 days following entry of the order to file a notice of participation in the litigation (with such notice including a brief statement of the claimant's position). A specified GO claimant listed in the annex to the objection (pasted above) would be specifically required to file the notice “or risk having a default judgment entered against it.” After such notices from all potential parties to the litigation are received, the objectors would propose preliminary recommendations on how to proceed with briefing and discovery. Claimants would have seven days to respond and the objectors would have three days to file a reply, under the procedures as currently proposed. Such briefing would be limited to the procedures to be applied in subsequent litigation, not the merits of the litigation itself.
According to the procedures motion:
Claim Objection
Press Release
Procedures Motion
The PROMESA oversight board’s special claims committee and the official committee of unsecured creditors in the Title III cases filed a joint objection on Monday evening, Jan. 14, seeking the disallowance of more than $6 billion of claims based on commonwealth general obligation bonds issued in or after March 2012.
In challenging more than $6 billion of GO bonds as “invalid,” the objection focuses on bondholders and monoline insurers that have filed proofs of claim that include the allegedly invalid GO bond claims of $50 million or more against the commonwealth. The claimants, which are identified in Appendix I to the objection, are ASM BLMIS Claims LLC; Assured Guaranty Municipal Corp.; Aurelius Investment LLC; Aurelius Opportunities Fund LLC; Autonomy Master Fund Ltd.; Brigade Capital Management LP; FPA Crescent Fund; LS Strategic Income Fund; Mason Capital Master Fund LP; and Prisma SPC Holdings Ltd. Segregated Portfolio AG. The filing includes a chart summarizing the information regarding each claimant, which is excerpted below:
“According to the claims registry maintained by Prime Clerk, more than 4,000 proofs of claim have been filed asserting bond-based claims against the Commonwealth. Many of these claims are based on bonds other than GO bonds. However, given the sheer volume of claims, it would be cost-prohibitive to review and analyze more than 4,000 proofs of claim to determine which ones, in fact, assert claims based on holdings of Invalid GO Bonds. The Objectors, therefore, limited their review to proofs of claim alleging more than $50 million of bond debt.”
According to the objection, of the $13 billion in outstanding GO bonds, “$6 billion of those GO bonds are invalid and that no claims based on those bonds are allowable against the Commonwealth.” The objectors contend that such debt is invalid because, among other things, it was issued in violation of the Puerto Rico Constitution’s debt service limit “when properly calculated” to include debt service on bonds issued by the Puerto Rico Public Buildings Authority, or PBA. In arguing that PBA bonds should be included in the calculation of the debt service limit, the objecting parties assert that the PBA structure is “a sham.” The filing contends that the commonwealth’s 2014 GO bonds “are invalid even without including debt service on PBA bonds.” The claim objection alternatively requests that to the extent such claims include unamortized original discount, such claims should be disallowed.
The objection further argues that the GO bonds are invalid because they were also issued in violation of Puerto Rico’s constitutional balanced budget clause. According to the objection, if approximately $425 million of interest that was excluded was included, “the issuance of the 2014 GO Bonds would have been shown to violate the Debt Service Limit (even without including debt service on the PBA Bonds)” (emphasis added). The board and UCC attach as Appendix II to their objection two versions of the debt limit calculation: one in which they exclude the $422.7 million of interest, concluding that the constitutional debt limit was not exceeded, and one in which they include that interest, concluding that the constitutional debt limit was exceeded.
Separately, the UCC also alleges that the debt violates the balanced budget requirement in Article VI, section 7 of the Puerto Rico Constitution, because proceeds of the debt were used to finance deficit spending.
The movants filed the declaration of James Bliss of Paul Hastings LLP, co-counsel to the UCC, which attaches copies of various documents relating to the claim objection, and Bliss also submitted an additional declaration indicating that the movants are not able to determine at this time whether any of the claimants subject to the claims objection are in military service.
Separately, the oversight board and the UCC filed a motion to establish procedures for the resolution of their claims objection, described below. The movants also filed a request expedited consideration of the procedures motion, proposing the following dates:
- Jan. 21 at 3 p.m. ET: deadline to object to the procedures motion;
- Jan. 25 at 3 p.m. ET: deadline for movants to reply in support of the procedures motion; and
- Jan. 30 and 31: a hearing on the procedures motion.
The EMMA links to the GO bond issues identified as “invalid” in the objection are below:
- $2.3 billion in Public Improvement Refunding Bonds, Series 2012 A, which were issued in April 2012;
- $415.27 million in Public Improvement Refunding Bonds, Series 2012 B, which were issued in March 2012;
- $3.5 billion in General Obligation Bonds of 2014, Series A issued in March 2014.
The oversight board said in the press release that it is “mindful of the extraordinary responsibility” it has been given under PROMESA and has the duty to act in the best interests of Puerto Rico and all of its creditors as the representatives of Puerto Rico in the Title III restructuring. “Challenging improperly issued debt is consistent with that duty,” the oversight board said.
According to the press release, the special claims committee described the investigation as “an integral part of the Board’s mission to restore fiscal balance and economic opportunity and to promote Puerto Rico’s reentry into the capital markets.”
The UCC is represented by Paul Hastings LLP as counsel and Zolfo Cooper LLC as its financial advisor. The special claims committee is represented by Brown Rudnick.
Claim Objection
The objectors explain that the issues raised in the filing are “gating issues” for the commonwealth’s plan of adjustment process. “From the outset, holders of GO bonds have claimed entitlement to a so-called ‘constitutional priority of payment’ such that, in their view, no other unsecured creditor of the Commonwealth can receive a single penny of plan distribution until all GO bondholders have been paid in full,” according to the filing. The special claims committee and the UCC note, however, that for a “number of reasons beyond the scope of this Objection,” they, along with numerous commonwealth creditors that include retirees and essential service providers, “do not agree that the GO bondholders are entitled to such a priority.”
“Nevertheless, whether more than $6 billion of GO bondholder claims should be disallowed is unquestionably a critical gating issue,” says the objection.
Before turning to the substance of the claim objection, the special claims committee and the UCC also include the following reservation of rights:
“The Objectors reserve their right to raise additional objections to the validity of other issuances of GO bonds, including on the basis that such bonds were issued in violation of the Debt Service Limit, whether because certain other debt was not properly included in the Debt Service Limit calculation or otherwise. In addition, the Objectors reserve their right to object to the Invalid GO Bonds on grounds other than those set forth in this Objection. Finally, the Objectors reserve their right to seek disallowance of any claims asserted against the Commonwealth relating to the PBA bonds, whether arising directly or from the Commonwealth’s guaranties, including as to any payments under the PBA Lease Agreements and/or the PBA bond issuances.”
After reviewing the constitutional debt service limit and the constitutional balanced budget clause, the claim objection provides an overview of the commonwealth GO bonds, including the issuances that the objectors argue are invalid, and the PBA bonds.
The objectors begin by arguing that the allegedly invalid GO bonds were issued in violation of the constitutional debt service limit under the Puerto Rico Constitution. As previewed above, the objection explains that “[t]he Debt Service Limit in Article VI, Section 2 of the Commonwealth Constitution limits the amount of debt the Commonwealth can issue by limiting the amount of future debt service the Commonwealth can take on relative to its past internal revenues.” The objectors note that new debt “cannot be issued if, when added to any payments by the Commonwealth in the prior fiscal year on account of debt guaranties, debt service on direct, full faith and credit obligations of the Commonwealth would exceed (in the current or any future fiscal year) 15% of the Commonwealth’s average internal revenues for the prior two fiscal years.”
As an initial matter, the objectors maintain that the allegedly invalid GO bonds were issued “in violation of the Debt Service Limit when properly calculated to include debt service on the PBA Bonds.” The objection contends that there can be “no dispute that, if debt service on the PBA Bonds is included in the calculation, the Debt Service Limit was first exceeded with the issuance of the Series 2012 B GO Bonds on March 29, 2012.” The filing charges that the commonwealth's average internal revenues for the two fiscal years prior to 2012 - 2010 and 2011 - “was $7.6004 billion.” According to the objectors, with the issuance of the 2012 B GO bonds, “the maximum debt service in any fiscal year (including PBA Bond debt service) was $1.2291 billion in 2020 (inclusive of $16.5 million of Commonwealth guaranteed debt payments made in fiscal year 2011), which is more than 15% (16.2% to be precise) of the Commonwealth’s average internal revenues for the prior two fiscal years” (emphasis added). Therefore, according to the claim objection, the commonwealth “proceeded to issue another $5.8 billion in GO bonds over the next two years, all of which also violated the Debt Service Limit.”
In arguing that PBA bonds must be counted toward the constitutional debt limit, the objection alludes to an adversary complaint filed by the oversight board and the UCC last month seeking a declaratory judgment that the PBA leases "are not 'true leases,' but, rather, disguised financing transactions."
Last night’s filing says: “Courts throughout the country have seen such public building authority structures for what they really are - transparent shams designed to circumvent constitutional debt limits. In the words of one such court, public building authority structures are “a scheme which would fool only a lawyer.”
The claim objection acknowledges that, in form, the PBA bonds “are not ‘direct obligations’ of the Commonwealth subject to the Debt Service Limit.” “In economic substance, however, they are exactly that.” The objection argues that the PBA structure “serves no other purpose than to finance the construction and improvement of buildings for the Commonwealth through the issuance of debt that, while not in the Commonwealth’s name, is payable (directly or indirectly) from the Commonwealth’s general revenues and depends solely on the Commonwealth’s credit.” According to the special claims committee and the UCC, the official statements for the PBA bonds “give away the game, as nearly all of the disclosure in the Official Statements is focused on the creditworthiness and activities of the Commonwealth, not the PBA.”
The objectors provide an overview of public building authorities created by other governmental entities. “From the beginning, public building authorities have had but one purpose - the circumvention of constitutional debt limits,” says the objection. While the PBA structure “differs in certain details from the traditional structure,” the objection maintains that the PBA “is no less a sham - in fact, it is more so.” According to the objection:
“As with the traditional structure, the rent payments and lease durations are not determined by the commercial real estate market or the fair market value of the property leased; rather, they are tied directly to the payment of debt service on the PBA Bonds and are paid (directly or indirectly) from the Commonwealth’s general revenues. In addition, the PBA Lease Agreements require the payment of rent even if the PBA Facilities are destroyed through no fault of the lessee, and any disputes are subject to binding resolution by the Governor, who appoints, directly or indirectly, all of the PBA’s board members. Moreover, the bonds and the rent payments are both guaranteed by the Commonwealth and backed by a pledge of the Commonwealth’s full faith and credit.”
The objection then reviews a series of state court rulings on public building authorities, asserting that “[s]ince the advent of public building authorities as a debt limit evasion device, courts in various jurisdictions have refused to countenance such a transparent artifice.” The filing also reviews certain decisions by the U.S. Bankruptcy Court for the District of Puerto Rico regarding true leases. In addition, the objection notes Detroit’s challenge to the certificates of participation, or COPs, structure as part of the chapter 9 case and draws comparisons between the COPs structure and the PBA, while acknowledging that the COPs structure was not a public building authority.
The objectors also contend, however, that the PBA structure in Puerto Rico “appears to be unique in that the Commonwealth explicitly ‘pledged’ its full faith and credit, not only to guarantee the rents payable by Commonwealth entities, but to guarantee the PBA Bonds themselves” (emphasis added). According to the filing, even if the commonwealth “had not explicitly guaranteed the bonds, it did so implicitly by guaranteeing the rents, which are the source of payment for the debt service.” Therefore, says the objection, the calculation of the debt service limit “must include” the PBA bond debt service (as opposed to guaranty payments made on account of PBA bonds) “because, in economic reality, PBA debt service is a direct obligation of the Commonwealth.”
However, even if PBA bond debt service is not included in the calculation, the objectors argue that the 2014 GO bonds “were issued in violation of the Debt Service Limit when properly calculated to include interest on the 2014 GO Bonds payable from the proceeds of the 2014 GO Bonds themselves.” According to the claim objection, while the 2014 GO bonds were issued in the aggregate principal amount of $3.5 billion, almost $425 million of the 2014 GO Bond proceeds “were used to pay interest on the 2014 GO Bonds during the first three years they were outstanding, and those interest payments were excluded from the calculation of the Commonwealth’s Debt Service Limit.” As a result, says the filing, the commonwealth “really borrowed approximately $3.1 billion for the intended purposes but, because the Commonwealth knew it would not have sufficient revenues to pay even the first few years of interest on the bonds, it borrowed money for that too” (emphasis added).
The plain language of the constitutional debt service limit calculation “does not depend on the source of payment for the debt service,” say the objectors, who argue that, as a result, the interest paid from the proceeds of the 2014 GO bonds “was ‘interest on such bonds’ just the same as interest on the bonds paid from any other source.” The objection explains that in calculating the debt service limit, “the Commonwealth did not include the nearly $425 million of interest to be paid from the proceeds of the 2014 GO Bonds themselves in fiscal years 2014, 2015, and 2016, thereby creating the appearance that the Debt Service Limit would not be violated.” The objectors reference Appendix II to the filing, which they say demonstrates that the issuance of the 2014 GO bonds would have been shown to violate the debt service limit (even without including debt service on the PBA bonds) had that interest been included in the calculation. The filing also points out that “the proceeds used to pay interest were not even held in a separate escrow account for that purpose.”
According to the objection, general obligation bonds “are traditionally issued to finance capital projects such as land acquisition and infrastructure development.” By contrast, the objection contends, the “Invalid GO Bonds were used (among other purposes) to finance deficit spending (directly or indirectly), which is not a purpose for which the Commonwealth had the power to borrow money.” Further, the filing says, the 2014 GO bonds were issued when the commonwealth was “already straining under an unsustainable debt load and had already engaged bankruptcy counsel to draft debt restructuring legislation” that was ultimately struck down by the Supreme Court.
The objection filed by the special claims committee and UCC continues, asserting that the English version of the Commonwealth Constitution provides that “[t]he appropriations made for any fiscal year shall not exceed the total revenues, including available surplus, estimated for said fiscal year unless the imposition of taxes sufficient to cover said appropriations is provided by law.” The Spanish version of the Constitution uses the term recursos totales, according to the objection, which in English means “total resources,” not “total revenues.” The question was taken up by the president of the drafting committee, who explained that recursos totales was meant to be broader than “total revenues,” which was the term used in the balanced budget clause of the Jones Act, which governed Puerto Rico until the adoption of the Commonwealth Constitution. The objection adds: “He further explained that ‘recursos totales’ was meant to include, among other things beyond tax revenues, the ‘issuance of bonds’ (translated from Spanish).”
While the Spanish version of the Constitution uses a term “that is broader than ‘total revenues’ and was meant to include some form of bond proceeds,” the board and UCC argue that the English version uses “total revenues” just like the Jones Act. According to the objection, because “revenues” does not include borrowings, “the constitutionality of deficit financing depends, as an initial matter, on which version of the Constitution controls.”
The objection continues, arguing that there can be “no doubt that it was the English version of the Constitution that the U.S. Congress approved.” As a consequence, the objection asserts, the “terms” in accordance with which the Constitution became effective “were the terms of the English version approved by the U.S. Congress; not the Spanish version debated at the constitutional convention.” The oversight board and UCC argue that it is “indisputable that, if the English version controls, deficit financing is constitutionally prohibited and, because they were used to finance deficit spending, the Invalid GO Bonds were not issued for a lawful purpose.”
In addition, the objection asserts that the invalid GO bonds are rendered "null and void" because they were issued in violation of the debt service limit and the balanced budget clause and, "as a consequence, the bondholders have no remedy." Citing Article VI, Section 9 of the Commonwealth Constitution, the objectors argue that when a government transaction violates Puerto Rico law, "a private counterparty has no remedy if the illegality implicates a clear public policy."
“The Debt Service Limit and the Balanced Budget Clause inarguably embody a clear public policy of the Commonwealth regarding the issuance of debt, and thus holders of the Invalid GO Bonds cannot recover under an unjust enrichment theory,” the objection states, citing several Puerto Rico Supreme Court cases.
The objection states that relevant case law demonstrates that equitable theories such as estoppel, unjust enrichment and ratification “are of no avail” and that the Puerto Rico Supreme Court has “‘unequivocally rejected’” the application of equitable estoppel as developed in the common law for use in its civil law system. The objectors also maintain that a similar doctrine known as “actos propios,” or the “doctrine of one’s own acts,” allows a court to apply equitable principles in the absence of any applicable law system via Article 7 of the Puerto Rico Civil Code. The doctrine applies to government action only "where the public interest would otherwise be harmed," and courts will not apply the doctrine if doing so would violate law or public policy, according to the objection. It also asserts that a fundamental commonwealth public policy expressed in its Constitution is that "the power of the Legislative Assembly to incur debt should be limited based on the Commonwealth’s internal revenues, lest political expediency lead to the accumulation of an unsustainable debt burden."
The objectors also assert that the doctrine of unjust enrichment cannot be applied in contravention of a clear public policy embodied in a statute or the Constitution. The same is true of ratification, says the objection, which also contends that under Puerto Rico law, if a government contract does not follow strict formation requirements and comply with all applicable laws, it is of no force or effect and cannot be ratified by later conduct.
"In short, a private party transacting with the Commonwealth takes the risk that, if the transaction runs afoul of a clear public policy embodied in a statute or the Constitution, no remedy will be available against the Commonwealth. Although a harsh result for the counterparty to an unlawful transaction, allowing a recovery against the Commonwealth (in whatever form) would be a much harsher result for the people of Puerto Rico as a whole. Laws governing the expenditure of public funds exist for one reason - to protect the interests of Puerto Rico taxpayers," the objection states.
The objection then turns to the GO bondholders’ potential defenses under Puerto Rico’s UCC Article 8, specifically section 8-202 (providing for the validation of securities under specified conditions as a defense to an issuer’s assertion of invalidity, according to the objection) and section 8-210 (providing a remedy to holders of “overissued” securities, according to the objection). The objectors argue that neither provision “gives rise to an allowable claim against the Commonwealth.”
First, the objection argues that “no statute can nullify the Constitution.” Citing a case from the Florida Supreme Court, the objection asserts that although a statute may “validate bonds originally issued without authority, provided the Legislature could have authorized the issuance of the bonds in the first place,” but such a statute cannot remedy a situation where “bonds are issued in violation of a mandatory provision of the Constitution.” In the later instance, says the Florida Supreme Court “such bonds are void ab initio, and cannot be validated by curative legislation.”
Next, the objection looks to the text of Puerto Rico’s UCC Article 8 and related statutes, including their remedy provisions and concludes:
“overissued securities cannot be validated, but holders of overissued securities are afforded a remedy under section 8-210. Here, the remedy would be, at best, an unsecured (but subordinated pursuant to Bankruptcy Code section 510(b)) claim against the Commonwealth for the purchase price paid by the bondholder (which, for many of the biggest bondholders, was presumably well below par)” (emphasis added).
The filing adds that section 8-202 is inapplicable for other reasons, including that this provision applies “only to claims of invalidity by the ‘issuer’ of the defective securities, and neither Objector was the ‘issuer’ of the Invalid GO Bonds within the meaning of the statute.” In addition, say the objectors, “deficit financing was not a purpose for which the Commonwealth had the power to borrow money” and “any bondholder invoking UCC 8- 202 has the burden of establishing such bondholder’s eligibility for validation.” The objection concludes this section by asserting that if a bondholder is an original issue purchaser, “section 8-202 is inapplicable on its face.”
The objection notes that most of the Invalid GO Bonds were issued with OID, citing the 2014 GO Bonds, which were issued at OID of 7%, or 93% of par. It asserts that Section 502(b)(2) of the Bankruptcy Code bars the recovery of “unmatured interest” and that bankruptcy courts have unanimously held that “unmatured interest” includes unamortized OID. The exclusion of original issue discount is to prevent creditors from claiming "disguised, unearned interest," according the objection.
The objectors state that "to the extent that OID on Invalid GO Bonds remained unamortized as of the Petition Date, the portion of any claims constituting such OID must be disallowed. The Objectors will establish at trial that, as of the Petition Date, more than $230 million of OID on Invalid GO Bonds remained unamortized."
Procedures Motion
The objectors separately moved for an order: (i) permitting the omnibus objection to the claimants listed in the chart above and the claims of those holders who elect to participate in the litigation, “even if the ultimate number of Challenged GO Bond Claims exceed one hundred”; (ii) establishing procedures for providing notice of and an opportunity to participate in the litigation to other parties in interest, including the AAFAF and the official retiree committee, and to all “actual and potential holders” of the challenged GO bond claims, “including those that have not filed claims or otherwise appeared in these Title III cases”; and (iii) establishing certain initial litigation procedures for all participants.
The objectors note that over 4,000 bond claims have been filed in the case and “unlike in the private debt issuance context, no indenture trustee exists that may serve as a representative for all holders of Challenged GO Bonds in these cases.” Given this, the objectors propose “litigation of the Objection and defenses thereto as part of one organized process as opposed to requiring Objectors to pursue their objections in strict compliance with Bankruptcy Rule 3007.” More specifically, the procedures propose to joint briefing, discovery and argument on the issue of “whether the Commonwealth issued the bonds in violation of the constitutional debt limit and/or the balanced budget clause of the Commonwealth Constitution.”
As for notice to potential GO bond claimants who have not filed claims or appeared in the case, the motion proposes notice be provided in newspapers and on the EMMA website and would order Cede and the Depository Trust Co., or DTC, to assist in the noticing process. Specifically, the procedures propose that an “objection notice” be distributed by CEDE and DTC. The notice would also be published in (a) El Nuevo Dia; (b) Caribbean Business; (c) El Diario and El Nuevo Herald; (d) The Bond Buyer; and (e) on the municipal bond website EMMA.
The objection notice would outline procedures for participating in the case. Under the procedures, parties that wish to participate in the litigation process would have 30 days following entry of the order to file a notice of participation in the litigation (with such notice including a brief statement of the claimant's position). A specified GO claimant listed in the annex to the objection (pasted above) would be specifically required to file the notice “or risk having a default judgment entered against it.” After such notices from all potential parties to the litigation are received, the objectors would propose preliminary recommendations on how to proceed with briefing and discovery. Claimants would have seven days to respond and the objectors would have three days to file a reply, under the procedures as currently proposed. Such briefing would be limited to the procedures to be applied in subsequent litigation, not the merits of the litigation itself.
According to the procedures motion:
“Proceeding with the Objection in this organized, omnibus fashion is the best way to determine the allowability of the Challenged GO Bond Claims in a timely and cost-efficient manner while minimizing the expenditure of the valuable resources of the parties and the Court. Moreover, it allows parties who wish to participate in the litigation of the Objection (either in support or against the relief sought in the Objection) who are not otherwise identified on Appendix I to the Objection, to participate by satisfying minimum procedural requirements.”
This article is an example of the content you may receive if you subscribe to a product of Reorg Research, Inc. or one of its affiliates (collectively, “Reorg”). The information contained herein should not be construed as legal, investment, accounting or other professional services advice on any subject. Reorg, its affiliates, officers, directors, partners and employees expressly disclaim all liability in respect to actions taken or not taken based on any or all the contents of this publication. Copyright © 2024 Reorg Research, Inc. All rights reserved.