Distressed Debt Investing: Puerto Rico

The topic on everyone's minds these past few weeks in distressed debt land has been Puerto Rico. While yields on traditional muni land paper have come in quite a bit over the past few weeks, I am going to go out on a limb and suggest, for the benefit of the doubt, PR will be a topic that we will be talking about for a LONG TIME. Frankly, the situation is bad (not to mention the forced selling aspects of when certain issuers lose their IG rating). The sheer amount of debt is staggering and we are not just talking about COFINA or PREPA or an off the run situation like the University of Puerto Rico but also all the PR based corps as well as the implications for the monolines.

We've started doing a lot of work at Reorg Research on Puerto Rico given these wide ranging implications and the sheer complexity and richness of its capital structure. Our first piece, one that we've been thinking about to introduce the legal ramifications of the case (we have a number of lawyers on staff now) I've reproduced below. Enjoy!

The 'Cracks' of the Bankruptcy Code? The Ambiguous Status of Government-Related Entities in U.S. Commonwealths

Recent attention on the precarious situation of Puerto Rico's economy has raised questions regarding the impact of Puerto Rico's status as a commonwealth territory on Puerto Rico's recourse to United States bankruptcy law.

Puerto Rico, like the United State's other commonwealth, the Northern Mariana Islands, is subject to the jurisdiction of the federal courts and are covered by the bankruptcy code. This is formalized in the code, which defines "United States," (when used in a geographical sense) to include "all locations where the judicial jurisdiction of the United States extends, including territories and possessions of the United States." As a result, "persons" domiciled in or with assets in Puerto Rico can be debtors under the code, just like persons in the fifty states.

Interestingly, the drafters of the code have not extended this equal treatment to chapter 9. Political subdivisions of "states" may file for chapter 9. The definition of "state" in the bankruptcy code "includes the District of Columbia and Puerto Rico, except for the purpose of defining who may be a debtor under chapter 9 of this title." According to Collier's, this exception "has the effect of preventing political subdivisions, agencies and instrumentalities of the District of Columbia and Puerto Rico from being debtors in chapter 9 cases." Under section 109(c), only a municipality is an eligible debtor under chapter 9, and that term means a political subdivision, agency or instrumentality of a state. For this purpose, "state" is limited to one of the 50 states of the United States.

It is also worth noting that the states and commonwealths themselves are not eligible to file for chapter 9 because they are not "municipalities" and only "municipalities" are eligible for chapter 9. According to the federal courts' "bankruptcy basics" page the definition of municipality, "is broad enough to include cities, counties, townships, school districts and public improvement districts. It also includes revenue-producing bodies that provide services which are paid for by users rather than by general taxes, such as bridge authorities, highway authorities, and gas authorities." But, there is simply no procedure in the bankruptcy code to deal with the insolvency of a "state" itself.

Another important limitation on government-related entities' recourse to bankruptcy law stems from the code's definition of who is a "person." Only "persons" can file for chapter 7 and chapter 11 relief. The code defines the term "person" to include "individual, partnership and corporation" but not "governmental units." "Governmental units" means "United States; State; Commonwealth; District; Territory; municipality; foreign state" and also any "department, agency, or instrumentality of the United States . . . a State, a Commonwealth, a District, a Territory, a municipality, or a foreign state" (emphasis added).

As a result of the above, the United State's commonwealth territories - Puerto Rico and the Northern Mariana Islands - are in the odd position that both their municipalities and their "governmental units" cannot file as debtors under any chapter of the bankruptcy code. Adding further confusion, there is no bright-line test as to whether a government-related entity is or is not a "governmental unit" for purposes of the code.

All of these factors were on display in a recent case from the Northern Mariana Islands. The Northern Mariana Islands Retirement Fund filed for bankruptcy on April 17, 2012, describing itself as a "public corporation and autonomous agency of the Commonwealth established pursuant to Public Law 6-17 to provide retirement security and pensions to the employees of the Commonwealth government." At the time of its filing, the fund estimated it was only 32% funded due to a "perfect storm" of factors including "the failure of the Commonwealth's central government and autonomous agencies to remit full employer contributions; a difficult investing climate over the most recent three to  four years; and a benefit structure that has been continuously increased and made more generous by the Commonwealth government without a corresponding increase in funding to the Debtor to cover increased costs," combined with the Commonwealth Government "declaring payment holidays, diverting earmarked revenues from the Debtor and reducing contribution rates for the Commonwealth Government, its agencies and political subdivisions." The fund estimated that it would deplete its assets by July 2014 and thereafter would be "unable to provide any level of benefits to current and future Beneficiaries."

Despite the extreme financial predicament of the fund, a variety of parties - including the Commonwealth Government and the United States Trustee's office, as well as individual retirees - moved to dismiss the bankruptcy, asserting the fund is an instrumentality of the commonwealth government and therefore a "governmental unit" not eligible for relief under chapter 11.

The fund's omnibus response to the motions to dismiss included the following arguments: The fund lacks traditional government powers and does not conduct traditional government  functions; the commonwealth government does not actively control the fund; and congressional intent requires an "inclusive" approach to eligibility. Interestingly, the fund also argued there was no "satisfactory alternative" to bankruptcy because it is not eligible for chapter 9 relief as a municipality of a "State" due to the definition of "State" in the bankruptcy code. The only alternative for the fund, according to its response, is receivership and receivership is not an alternative to bankruptcy since receivership would "essentially constitute a liquidation" and lacks the protections of the bankruptcy code that help debtors achieve a "fresh start." A footnote in the fund's response states that, if denied bankruptcy eligibility, it would "fall between the cracks" of the bankruptcy code.

Judge Robert J. Faris sided with those seeking to dismiss the case and ruled that the fund was ineligible to be a debtor. Judge Faris rejected an "alternative relief" test which would have looked at the fund's non-bankruptcy alternatives. He called this approach, "completely unmoored from the statutory text." Faris concluded that the key question is whether the fund is an "instrumentality" of the commonwealth but found dictionary definitions of the term "instrumentality" lacking a plain meaning. Instead, Faris relied on legislative history and concluded that the intent of Congress was to define "instrumentality" broadly so long as the relationship between the entity and the government is "active...in which the department, agency, or instrumentality is actually carrying out some government function." Faris concluded that "providing compensation and benefits to government employees is a quintessential government function." The opinion also relies heavily on the fact that the fund's plan serves only government employees and retirees, and that the Commonwealth has "significant ongoing influence over the Fund." Judge Faris contrasts this with a Third Circuit decision in the Nortel case that ruled that a UK entity established by the government to guaranty obligations of failed private pensions plans was not a "governmental unit." Faris distinguished Nortel because in that case the fund "was funded entirely by private employers and benefitted only nongovernmental employees."

The Northern Mariana Islands Retirement Fund case is notable because it shows the precarious situation of government-related entities in the United States' territories. Judge Faris showed no inclination to look at the non-bankruptcy alternatives available to the fund, and instead relied on a the text and legislative history of the bankruptcy code to decide whether it was a "governmental unit." However, it is unclear if the drafters of the bankruptcy code truly intended to leave "governmental units" in the territories ineligible under both chapter 11 and chapter 9. The consequence for the Northern Mariana fund was drastic. Various retirees sued both the fund and the Northern Mariana Islands government and the result is a recent settlement agreement whereby the fund is being taken over by a receiver and retirees will face haircuts to their benefits.

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hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.