Puerto Rico May Be the Next Big Bailout for U.S. Taxpayers
Although financial optimists are heralding the recent sale of $3.5 billion of bonds by the Commonwealth of Puerto Rico as the end of the financial crisis for the island and its inhabitants, a closer look demonstrates that the bond sale may, at best, be a small bandage on a large and hemorrhaging wound. Because of the uniqueness of Puerto Rico's status as a Commonwealth of United States, a financial default by Puerto Rico will be catastrophic in that it will almost mandate a bailout by the U.S. Government which will ultimately be borne by U.S. taxpayers.
What most financial experts may not recognize or be unwilling to disclose is that Puerto Rico, unlike a municipality, cannot under existing U.S. bankruptcy laws file for relief under any chapter of the Bankruptcy Code. Unlike Detroit, Michigan; Harrisburg, Pennsylvania; Jefferson County, Alabama; and Orange County, California, where an organized financial restructuring has been or is being structured under the auspices of a bankruptcy court, a commonwealth of the United States, which is the official status of Puerto Rico, is not eligible to file a Chapter 9 municipality reorganization proceeding. Additionally, there is no provision in the Bankruptcy Code for a commonwealth to seek relief under Chapter 11 which is the reorganization vehicle for business entities. This means that unless the U.S. Government is willing to permit the entire Puerto Rican government to fail, a substantial bailout could the only way out. The potential cost to the U.S. taxpayers cannot be measured.
When the proceeds of the current bonds have been expended, if any older bonds become due or if there is a precipitating factor to accelerate the continuing financial uncertainty in Puerto Rico, and creditors seek to collect on obligations of the commonwealth, there is no place for the government to seek refuge under existing bankruptcy laws. This, then, will lead to a free-for-all and feeding frenzy by bondholders, retirees, labor unions, creditors and others that are owed monies by the Puerto Rican government, as each will seek to gain an advantage over the other to be the first in line to be paid.
Interestingly, the underwriters for the just completed bond offering reaped underwriting fees of $28.1 million which amounts to $8.04 for every $1,000 of securities sold. This is an unprecedented high fee for bonds of this nature, and is 27% higher than when Puerto Rico last sold bonds. The increased fee which the underwriters were able to demand and obtain reflects their own pessimism as to the investment quality of the bonds and the fact that before the sale, they thought that they may be required to purchase the bonds on their own if the public refused to support the offering.
One of the benefits of U.S. bankruptcy law, which includes Chapter 9 for municipalities and other governmental agencies, is that when the case is filed, an automatic stay is entered which precludes creditors from taking any action to collect or enforce a debt obligation. The municipal entity can then, under the auspices of the bankruptcy court, negotiate with the various classes of creditors and formulate a plan of adjustment of debts, the fairness of which must be approved by the bankruptcy judge. As in Chapter 11 for businesses, this precludes the free-for-all chaotic situation which is created when there is nothing to forestall creditor action. The absence of the court refuge then leads creditors to act precipitously so that they can be first in line to get paid with whatever assets are available for the creditor body as a whole. When this occurs without court supervision, it impedes the day-to-day ordinary course of governmental activities if creditors are seeking to enforce debts. Furthermore, the entire situation is compounded by the fact that the law is somewhat uncertain as to whether Puerto Rico as a commonwealth enjoys the sovereign immunity granted to states and the Federal Government by the U.S. Constitution.
Within the last year, the Puerto Rican government has enacted many austerity measures to increase taxes and to reduce spending. However, the rampant unemployment of the populace and the general dependence on government employment has created a downward spiral for the island's economy. This has been exacerbated by the government's austerity plan which accounted for 76% of the payroll jobs lost between 2010 and 2014, and with 40% of the jobs lost last year. The Commonwealth currently has a 14+% unemployment rate, and is growing.
All of this leads to a potential disaster in the event that Puerto Rico is unable to very promptly devise and implement sufficient financial restructuring in order to pay its bills after June 2015 which is when the most recent borrowings will have been depleted. If bondholders, creditors, contractors or others become spooked or feel insecure with respect to Puerto Rico's financial future, the Commonwealth plus the United States Government could be faced with an unprecedented financial disaster absent either an immediate bailout from Washington or Congressional change to the Bankruptcy Code. From a bankruptcy perspective, there is no optimism on the horizon.