The Back Story on Puerto Rico’s Debt Crisis – The Hill (Sept. 4, 2015)

A basic question involving Puerto Rico’s debt crisis needs answering:  How did this island of 3.5 million residents create a $72.2 billion fiscal catastrophe when the government was supposedly constrained by a constitutional balanced budget requirement and a debt service limit?

First, to be as generous and fair as possible, let’s peel away $33.7 billion consisting in $29.6 billion in revenue bonds of government-owned utilities and $4.1 billion in bonds of the island’s 78 municipalities. Although some of this debt is guaranteed by the central government and while the government may have commingled some borrowed funds and repayments of the numerous entities involved,[1] this article focuses on the $38.5 billion[2] of explicit tax-supported debt. It is this debt that most confounds the relevant taxpayer protections of the Puerto Rico constitution.

These protections obviously failed. And to add insult, as the borrowing crested during 2011-13, instead of accruing significant visible public improvements and infrastructure, the U.S. territory jettisoned two major toll roads and San Juan’s international airport to private parties in order to monetize their cash flows for about $1.8 billion. This was on top of more than $5 billion borrowed during this period.  It’s not entirely clear how the government used these funds.

Foremost among the players in this decades-old drama were local politicians struggling to stay in office. They, in turn, received support from battalions of self-interested financial and professional service firms who stood to benefit from fees generated in bond deals.

The first constitutional casualty was the island’s balanced budget requirement. Herein lies an inglorious landmark of Puerto Rico’s legal order that was flubbed (perhaps intentionally) in translation. The official English version of the Puerto Rico constitution – the version approved by the United States Congress in 1952[3] – provides that “appropriations” for any fiscal year “shall not exceed total revenues, including available surplus, estimated for said fiscal year, unless the imposition of taxes sufficient to cover said appropriations is provided by law.”[4]

In contrast, the Spanish text translates the English term of “total revenues” as “recursos totales.[5]Recursos totales” is most accurately translated as “total resources.” This, of course, is broader than “total revenues,” which historically for Puerto Rico connoted tax revenues.[6]

During the debates of the Puerto Rico Constitutional Convention, one of the delegates argued that “recursos totales” included proceeds from government bonds. Therefore, the government could use loans to balance the budget. Twenty-two years later, during the depths of the 1974 recession, Puerto Rico’s attorney general pointed to the constitutional debates in rendering an opinion adopting this view.[7] Aside from the obvious fiscal hazards of this interpretation, the attorney general’s opinion ignored the official English text of Puerto Rico’s constitution. As the island’s constitution depended upon Congressional approval of the English version, it seems logical and consistent with Congress’s requirement pertaining to revisions and amendments that it should control.[8] This is in addition to the fact that Official Statements for Puerto Rico bonds are always written in English and refer to English texts of applicable laws.

Once the government adopted the attorney general’s opinion, little stood in the way of using bonds to balance the budget. Unlike other stateside jurisdictions, [9] Puerto Rico does not provide taxpayer and citizen standing to legally challenge public debt before it is incurred.[10]

Yet in subverting the balanced budget mandate, politicians used another method as well.  This consisted of the practice of regularly overestimating tax revenues each year and then taking the position that as long as “estimated revenues” matched appropriations, the budget was balanced. The notional balanced budget persisted even if loans were required to close deficits as the fiscal year progressed. This baffling interpretation of the constitution rendered the balanced budget requirement virtually meaningless. “Balancing” the budget each year became a cinch.

The next legal sacrifice was Puerto Rico’s debt limit. Prior to 1961, U.S. law banned the island from borrowing in excess of 10% of the tax value of the island’s real property. This is essentially the same debt limit that continues to apply to the U.S. territory of Guam.[11]  However, in 1961, Congress was swayed by the island’s great economic strides and the charisma of then governor Luis Muñoz-Marín to repeal the federal debt limit and allow the island to adopt its own limit by constitutional amendment. In hindsight, this was a monumental mistake by Congress.

Today, the island’s constitutional debt limit applies to the government’s “direct obligations” supported by a pledge of the full faith, credit, and taxing power of the Commonwealth of Puerto Rico (curiously translated in Spanish as Estado Libre Asociado, literally in English “Free Associated State”). It also applies to amounts paid on indirect debts “guaranteed” by the government. The limit bans further direct obligations and additional guarantees of indirect debts once annual principal and interest payments exceed 15% of the average of the last two years’ tax revenues.[12]

Counting only general obligation bonds of $14.2 billion,[13] the debt service limit should have been reached by the end of fiscal year 2015.[14]Yet, as noted at the beginning, the total tax-supported debt of the central government amounts to $38.5 billion.  How could this happen?

Enter so-called “appropriation debt.” Since 2000, Puerto Rico issued bonds indirectly through government-owned entities and made repayment contingent upon the Legislature’s appropriating funds for this purpose.  In theory, appropriation bonds are not “debt” under the debt limit, even if taxpayers were ultimately paying the bill.  To its credit, the government betrayed its own discomfort with this idea by dubbing it “extraconstitutional debt.”[15]

After peaking in 2006 at $9.5 billion, the island’s appropriation debt now stands at about $4 billion.[16] While it expressly disavowed a legal duty to make appropriations to pay these bonds, in practice the Legislature consistently made them until August 2015. Thus, for about 15 years, Puerto Rico appropriation debt was, for practical purposes, guaranteed by the government and charged to its taxpayers. And yet, it was not counted toward the debt limit. Another plausible characterization is that these unenforceable appropriations were mere gifts of public funds.

The nonpayment on Puerto Rico Public Finance Corporation bonds in August of this year involved appropriation debt.  While I salute the government’s decision to refrain from the PFC appropriation and thus (finally) start to vindicate taxpayer rights, I do so based on the arguable illegality, not just the unenforceability, of the underlying bonds. These appropriation bonds should not have been issued in the first place as their manifest purpose was to evade the constitutional balanced budget requirement and debt limit while burdening taxpayers.

An additional way around the debt limit was the creation of the Puerto Rico Sales Tax Financing Corporation, known locally as COFINA.[17]This acronym stands for yet another creative translation of Corporación de Financimiento de Interés Apremiante. Literally, this name would read in English as the “Urgent Interest Financing Corporation.” But this moniker might have spooked investors.

COFINA was created in 2006 following legal challenges to appropriation bonds used in other states to evade debt limits.[18] In addition to evading the balanced budget requirement and debt limit, COFINA took over some $7 billion in appropriation debt.[19]  In the six-year period from 2006 to 2013, the government used COFINA to borrow a total of $15.2 billion,[20] an amount exceeding the constitutional debt owed to general obligation bondholders. Island taxpayers are footing COFINA’s bill with a sales tax raised in July from 7% to 11.5%, reportedly the highest in the U.S.

COFINA has other problems as well. Its governing law purports to abrogate general obligation bondholders’ constitutional right of first priority to “available revenues”[21] with respect to the island’s sales taxes.[22] COFINA then funnels these sales taxes to its bondholders. Moreover, the Puerto Rico government “assures” COFINA bondholders that no future legislature may undermine their right to repayment by amending the law.[23] It is difficult to see how this does not constitute a guarantee of indirect debt that must be counted for purposes of the debt limit. All told, COFINA is legally suspect at best.

Barring an unlikely bailout by the United States, Puerto Rico’s debt crisis should culminate in a needed showdown of bondholders with competing rights and priorities. To vindicate taxpayer protections and prevent another fiscal calamity, Puerto Rico courts should finally stop the monstrous charade by enforcing the island’s law and showing all concerned parties that, from start to finish, the island’s constitutional fiscal restrictions are paramount. To this end, those who bought debt declared illegal can seek relief, not from Puerto Rico’s taxpayers, but from the financial institutions, professional services firms and individual government officials who helped orchestrate this epic disaster.

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