The latest installment in our series “Current News on the Commonwealth of Puerto Rico.”
On June 30, 2016, the “promise” became a reality as President Barack Obama signed the Puerto Rico Oversight, Management and Economic Stability Act, aka PROMESA. As asset managers focused on the interests of investors in the municipal bond market, we are hopeful that PROMESA will live up to the expectations of its stakeholders and will represent a strong first step forward for bondholders and for Puerto Rico.
As long-time investors in the municipal securities issued by the Commonwealth of Puerto Rico and its instrumentalities, we welcome the transparency and accountability that are embedded in the law, which requires the government to develop a new fiscal plan, to develop and enact balanced budgets (and legislation) that conform to the fiscal plan, and to deliver audited financial results in a timely fashion.
We note that PROMESA – which was passed with rare bipartisan support – seems to have successfully balanced the interests of many stakeholders. To quote from the law itself, PROMESA recognizes both the importance of providing Puerto Rico and its instrumentalities with “a method to achieve fiscal responsibility and access to the capital markets” and the need for debt restructuring proposals to be “feasible and in the best interest of creditors.”
The establishment of a federal control board, which is charged with mapping Puerto Rico’s path forward, has the potential to be PROMESA’s greatest strength, we believe, though a lot depends on the board’s composition and approach. One only has to look at the fiscal turnarounds in New York City and Washington, D.C. – both of which had similar oversight mechanisms – to see how a responsible control board can guide a troubled municipality to a stronger future.
PROMESA specifies that board members must have “knowledge and expertise in finance, municipal bond markets, management, law, or the organization or operation of business or government,” according to a summary of the law prepared by the House Committee on Natural Resources. Members will be reimbursed for expenses but receive no payment for their services, the governor or the governor’s designee may serve on the board in an ex officio capacity, and the board may hire an executive director as well as U.S. or Puerto Rico government employees.
Talks are underway about the composition of the control board, which will have seven members. President Obama will pick one member on his own and will pick the remaining six from lists developed by Congressional leaders: two members from the Senate majority’s lists, two from the House majority’s lists, and one each from the lists of the Senate and House minority. Members will be appointed to 3-year terms and can be reappointed; a plan exists to fill any vacancies that arise.
PROMESA stipulates that the federal control board cannot be terminated before three conditions are met: 1) Puerto Rico has “adequate access” to capital markets at reasonable rates; 2) the Commonwealth has developed budgets “in accordance with modified accrual accounting standards” for four consecutive years; and 3) the government has achieved balanced budgets.
PROMESA gives the control board’s many rights and responsibilities, including the following:
- The board will certify and protect voluntary restructuring agreements between creditors and debtors, such as the agreement that is in the works between PREPA (Puerto Rico’s electric utility authority) and its bondholders, including Oppenheimer Rochester.
- The board will establish the process and deadlines related to developing a fiscal plan. While it is the governor’s responsibility to deliver “an approvable and certifiable” plan by the deadline, the board can draft, adopt and enforce its own plan if the governor fails to do so.
- The board will enforce balanced budgets and government reform if Puerto Rico does not do so independently. It can, for example, sell government assets or introduce efficiencies by consolidating government agencies or reducing the Commonwealth’s workforce.
- The board can request audited financial statements, conduct hearings and, if necessary, impose criminal penalties “for knowingly providing false and misleading information, or refusing or failing to take any action” ordered by the board.
Several provisions, it appears, were designed to protect bondholders. To quote PROMESA, for example, any adjustment of debts must “respect the relative lawful priorities or lawful liens, as may be applicable, in the constitution, other laws, or agreements of a covered territory or covered territorial instrumentality, in effect prior to the date of enactment of this Act.” Importantly, before any instrumentality of Puerto Rico can seek to restructure its debt, the federal control board must certify that the debtor (i.e., Puerto Rico or one of its instrumentalities) has made good faith efforts to reach a consensual restructuring with creditors; has delivered draft financial statements and has procedures in place to deliver timely audited financial statements, and has a fiscal plan, among other provisions.
The law also seeks to prevent the government of Puerto Rico from exercising “any control, supervision, oversight, or review” over the federal control board and makes it clear that neither Puerto Rico’s governor nor its legislature can “enact, implement, or enforce any statute, resolution, policy, or rule that would impair or defeat the purposes” of PROMESA.
Additionally, according the summary from the House Committee on Natural Resources and assuming PROMESA works as envisioned, a firewall will exist between the constitutionally protected creditor hierarchy and pensions, which should further protect bondholders.
The new law requires that the governor submit a report at the end of each fiscal quarter with the revenues, expenditures and cash flow for the prior three-month period. PROMESA gives the federal control board the authority to remedy any variances with the certified budget, if the governor fails to do so within an established timeframe. Further, new laws passed by the Puerto Rico Legislature must include a cost estimate and be certified by that body as being consistent with the fiscal plan.
PROMESA also provides for an expedited permit review process for infrastructure projects that are deemed “critical.” If the federal control board makes recommendations to the governor or the Legislature, they must respond with a report indicating how the recommendations will be implemented or why they will be ignored.
Separately, a new bipartisan, bicameral Congressional Task Force will develop a report and make recommendations by year-end about any Federal laws or programs that are impeding Puerto Rico’s economic growth.
Bondholders may be justified in their concerns that PROMESA automatically stays any litigation against Puerto Rico and its instrumentalities. They should be heartened that – to the extent the board deems it feasible – scheduled interest payments should be made during the stay. Additionally, the U.S. District Court for Puerto Rico may provide relief from the stay in order to prevent irreparable damage. As of this writing, the stay is set to expire February 15, 2017. However, the control board and the U.S. District Court may seek to extend the stay for a combined total of 135 days.
Many Puerto Ricans have expressed concerns about the PROMESA provision that could mean lower wages for the youngest members of the Commonwealth’s workforce. The law grants the governor the authority to exempt employers from paying employees who are 25 or younger the national minimum wage. This exemption, which is subject to the board’s approval, would be in effect for a period of no more than 5 years.
A second provision temporarily exempts Puerto Rico from regulations related to overtime pay for various employees. This exemption will remain in place until the U.S. Government Accountability Office (GAO) conducts and completes a study about the economic condition of the Commonwealth and the U.S. Secretary of Labor considers the study and recommends to Congress that Puerto Rico should again comply with the overtime pay regulations.
We will leave it to the historians – not the politicians – to assess whether Puerto Rico’s shortfall had more to do with political will than cash flow.
For now, we are cautiously optimistic that Puerto Rico – under the oversight of a federal control board- will embark on a path of fiscal and economic reforms that enable it to grow, to provide for its inhabitants, to re-establish access the capital markets and to meet its obligations to its creditors. We remain confident in the fundamental overall strength of the $3.7 trillion U.S. municipal market and its ability to generate tax-free income over the long term to investors with varied financial needs and objectives.
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Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates, or an expectation of rising interest rates in the near future, will cause the values of a Fund’s investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at, or near, historic lows. When interest rates rise, bond prices fall and a fund’s share price can fall. Municipal bonds are subject to default on income and principal payments. Further, a portion of some funds’ distributions may be taxable and may increase alternative minimum tax (AMT) for investors subject to that tax; distributions from net realized capital gains are taxable as capital gains.
The funds invest in below-investment-grade debt securities, which may entail greater credit risks, as described in each fund’s prospectus. These securities (sometimes called “junk bonds”) may be subject to greater price fluctuations and risks of loss of income and principal than investment-grade municipal securities. The funds may invest substantially in municipal securities within a single state or related to similar type projects, which can increase volatility and exposure to regional issues. The funds may also invest substantially in Puerto Rico and other U.S. territories, commonwealths and possessions, and could be exposed to their local political and economic conditions. Deterioration of the Puerto Rican economy could have an adverse impact on Puerto Rican bonds and the performance of the Rochester municipal funds that hold them.
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