Is Puerto Rico Going Bankrupt? | Levin Papantonio Rafferty - Personal Injury Law Firm

Is Puerto Rico Going Bankrupt?

The island of Puerto Rico is neither a sovereign nation, a state, nor strictly speaking a U.S. territory – although it has been under U.S. control for going on 120 years. Its residents are considered U.S. citizens, yet they cannot vote in U.S. elections, and have only limited representation in Congress. Except for federal employees and members of the U.S. military, Puerto Ricans pay no federal income tax, but do have their own elected governor and legislature.

In some ways, Puerto Rico's status offers the best of both worlds – and in other ways, the worst.  For example, although Puerto Rico has very little voice in Washington D.C., it is still subject to laws passed on Capitol Hill – including the federal bankruptcy code.  As the island's legislature found out this week, laws passed in Washington still take precedence over those passed in San Juan.

A High Income Economy?

The name “Puerto Rico” translates into English as “The Port of Riches,” which is ironic, given the island's current economic situation. It is true that the World Bank considers Puerto Rico as a “high income economy,” while the World Economic Forum lists it as “the most competitive economy in Latin America.” Compared to many other Latin American countries, this is certainly true. Furthermore, Puerto Rico has enjoyed a relatively low rate of inflation over the years.

On the other hand, the poverty rate in Puerto Rico is twice that of Mississippi. Furthermore, Puerto Ricans suffer from an average unemployment rate of nearly 14%, and labor under a public debt that is equal to 66% of its GDP. At present, Puerto Rico's public debt totals $73 billion.

The Background

For much of its history, Puerto Rico's economy was agrarian-based, sugar being the main crop. After the Second World War, a  federal program known as “Operation Bootstrap” began encouraging the growth of manufacturing and other industries by offering various tax incentives in order to encourage investment – and by extension, the creation of jobs.  A large part of this was Section 936 of the Internal Revenue Code, allowing corporations operating in U.S. possessions to enjoy significant tax benefits. As a result, various industries, including petrochemicals, pharmaceuticals, clothing manufacturing and electronics began to replace agriculture as the island's main source of revenue.

That provision of the I.R.C. was eventually phased out, and expired in 2006. Since then, coupled with Puerto Rico's dependence on oil to run its industry and infrastructure and food imports, the expiration of Section 936 has caused a serious reduction in revenue. Furthermore, because of various “free trade” agreements between the U.S. and other Latin American countries, Puerto Rico finds itself having to compete with industries in countries in which workers are paid significantly lower wages.  Industries that were labor-intensive and low-tech stopped setting up shop in the Commonwealth, and educated Puerto Ricans began leaving for better-paying opportunities in the U.S. and elsewhere long ago.

By 2009, Puerto Rico's credit rating had fallen to “junk bond” levels.  Forty-four cents out of every dollar went to the island's deficit. Then-governor Luis Fortuño took action by enacting drastic government cuts. While these austerity measures had some short-term benefits, critics predicted that they would fail to address “long-term structural challenges.”

From Bad To Worse

The critics turned out to be correct. In attempts to shore up its faltering economy, Puerto Rico began doubling down on the sale of bonds. Puerto Ricans do not have to pay taxes on the income or gains from Puerto Rican securities because of a clause in the legislation that finally made Puerto Ricans full U.S. citizens in 1917. That law, known as the Jones-Shaforth Act, provided for a “triple tax exemption” on interest payments made to holders of Puerto Rican bonds. This was likely a selling point by advisors at financial juggernaut UBS and other investment firms who aggressively steered clients into these high-risk bonds. These bonds were purchased “on margin,” or with borrowed money – a situation that played a major role in the Crash of 1929.

When the current crash came in 2013, investors wound up having to liquidate their investments in order to meet “margin calls” (in other words, “pay up or else”), selling these junk bonds at a fraction of what they had paid for them, then having to sell other assets – including valuables, real estate and more – in order to cover the losses. 

Taking Cover

The current crisis has drawn in several of Puerto Rico's public corporations, including those that operate vital public services, such as the Puerto Rico Electric Power Authority (PREPA).

In a situation like this, a privately-held company can seek protection under Chapter 11 of the federal Bankruptcy Code.  Similarly, a municipal government (a city or county) can file under Chapter 9. However, public corporations such as PREPA “fall into an unintended gap in the legal system.” Neither proverbial fish nor fowl, such entities have no options when it comes to fending off creditors long enough to overcome financial difficulties.

Concerned that current legal action by investment firms could interfere with the delivery of services to ratepayers and threaten jobs, the legislature in San Juan passed the Debt Enforcement and Recovery Act in June of 2014. While well-intentioned (and applicable only to public corporations, not to issuers of general obligation bonds), those who wrote the law overlooked the Supremacy Clause of the U.S. Constitution. Article Six, Clause 2 provides:

[T]he Laws of the United States which shall be made in Pursuance thereof; and all Treaties made, or which shall be made, under the Authority of the United States, shall be the supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any State to the Contrary notwithstanding.

In short, U.S. federal law trumps state – and in the present case, Commonwealth – legislation. This includes bankruptcy law, which is under federal jurisdiction; a state or territory cannot pass its own laws in this regard. That was the recent ruling of federal Judge Francisco Besosa, who struck down Puerto Rico's law in a 75 page ruling. The plaintiffs in the case – which include Blue Mountain Capital as well as mutual funds under management of Franklin Templeton and Oppenheimer Funds – can proceed with attempts to recoup their losses on behalf of their investors.

It raises the question, however, of just what the plaintiffs might be able to recover. The original problems remain. A spokesperson for Puerto Rico's General Development Bank told the New York Times that they will review “all the aspects of the ruling” and “decide on a course of action.” At the same time, a chief executive with private equity firm Fundamental Advisors, which is invested in Puerto Rican bonds, calls the ruling “a victory for the rule of law,” but admitted to the Times that “the question is what’s next in terms of dealing with PREPA’s debt.”

For more information regarding the UBS Puerto Rico Bond Litigation, click on Levin Papantonio UBS PR Lawsuit.