The Oversight Board relationship: 'The beginning of a beautiful friendship'
The initial stages in the life of the Financial Oversight Board for Puerto Rico (the 'Board') was seen by many as painfully slow, but a recent flurry of letters initiated by the Board requiring the local government to submit a two-year budget balancing act, shows that the Board's advisers are finally starting to roll. In a fourteen-page letter by Jose Carrion, the Board's president asks the Rosello administration to adopt stringent austerity measures, impose new tax measures sufficient to fill an estimated fiscal gap of $7.0 billon (from FY 2016 to 2019) and details a series of very specific fiscal plan targets and guidelines.
However, the rapid reply salvo by the Rosello administration sent a clear message that the new local 'sheriff' stands ready to defend the puertorican pride and even public payroll, and that he is no less a savior of the puertorican people than his predecessor Garcia Padilla. The Board's short and sweet counter reply is reminiscent of the final Casablanca film episode in which Rick (Boggart) and Captain Renault walk away down an empty airport strip and Boggart ends by saying: 'I think this is the beginning of a beautiful friendship', or something to that effect.
Another possible confrontation between Board and the new local government involves the role to be played by the Board in the 'voluntary' negotiations with creditors that are taking place under article VI of the Puerto Rico Oversight, Management and Economic Stability Act ('PROMESA') ('the Act'). In article VI of PROMESA, Congress provided a powerful tool for local territories to use in bringing recalcitrant bond-holders to the table and forcing a debt haircut, subject to the imposition of majority rule on dissident holdouts, through the use of the collective action clause (CAC) mechanism.
The concept, which has been adopted legislatively and with retroactive effect in PROMESA, is not available to states or municipalities in the U.S., is normally used in the European Union mostly by contract and mutual agreement between the parties, and with only prospective application in mind.
The extent and role of the Board in executing the powerful CAC provisions had been somewhat ambiguous, until it recently explained that the Board has primary authority in the process of negotiating settlements with the different groups of creditors, and even before considering taking any action under the Act's article III bankruptcy court scenario. In fact, the January 18th letter requests that the Board be included and scheduled in any discussion with creditors, and makes clear that PROMESA does not allow any article VI agreement with creditors without Board's approval.
Surprisingly, the Board recently disclosed that a dozen or so private meetings have occurred in the last few months with various groups of creditors, which implies that transparency, at least under article VI of the Act, leaves a lot to be desired.
It also appears that the Board as well as the newly installed Island government want to nudge creditors into voluntary article VI agreements, hopefully along the 'securitization' model used to arrive at the tentative 15% haircut agreement with some of the Prepa bondholders. Both Board and government seem intent on using everything in their power to avoid the article III bankruptcy judicial option, probably because they will loose control under this method to a judicial officer.
No one bothers considering the dangers and pitfalls of the so called 'securitization' model, a form engineered to avoid the sound constitutional GO creditor priorities and protections; getting round the 15% constitutional ceiling on debt; and creating the questionable 'extra-constitutional' category of public debt. Securitization also implies turning unsecured, non-constitutionally protected and unpledged debt into a form of income-pledged, securitized or quasi secured credit.
Also, current hedge fund creditors, in exchange for taking a haircut and accepting the negotiated swaps, will probably require the Puerto Rico government to agree that any new emission issued be subject to New York law and the jurisdiction of federal courts in the District of New York. Basically the local government will be asked to give up one of the strongest tools it has in negotiations for debt reduction, which consists of the traditional inclusion of Commonwealth of Puerto Rico court venue and local law applicability, as done in most all of the bond offerings issued up to now.
Another issue that needs to be discussed is that contrary to current PROMESA article VI negotiations, an article III judicial process would require full transparency and access by all citizens to court files, federal court supervision and exclusion of political interference and appointments in the process. Above all, the article III court process requires a very rigorous professional conflict avoidance test, something the Board and the Puerto Rico governments (past and present) seem to want to sidestep at all costs.
Contrary to the out-of-court process, the article III judicial bankruptcy filing should require that each application for professional appointment certify that there is no conflicting situation due to prior representation of any party or by having issued opinions related to the bonds in question. The strict 'disinterested' professional test of the U.S. Bankruptcy Code would be required by the federal court, before appointing the numerous advisors and attorney firms to represent the various agencies and creditor committees participating in the bankruptcy court under article III.
Up to now the Board and the current local government administration has tended to avoid various conflict issues that have been publicly raised, maybe due to the embarrassing accusations faced by the Board itself in terms of being undemocratically imposed, having politically appointed and conflicted board members, lack of transparency and even conflicts in the appointments of attorneys and advisors as explained in the recent public audit reports.
The Board, as well as the past and current administrations, have ignored the issues raised in two Puerto Rico Audit Committee reports which describe numerous possible conflicts by underwriters, advisors and attorney firms, and who according to the two audit committee reports, may be responsible in part for the municipal debt crisis of the Island.
Furthermore, the Committee for the Audit of the Puerto Rico Public Debt created by law # 97 of 2015, which included seventeen members of academia, government, and labor participants, was unfunded and unsupported by the past administration, and has now been stopped in its tracks by the current government, which decided last week to dismiss the appointed committee members.
Along the same lines, the Board announced in its January 18th letter that they are in the process of hiring a firm that has done forensic audits in order to verify the past administration's (FY 2014, 2015 and 2016) unaudited figures, and to 'validate the bridge between Commonwealthâ€˜s last audited financial statement as of June 30, 2014 and the fiscal plan' for use of this data in the governments financial plan.
Clearly, a verification of numbers by a 'forensic firm' does not constitute a forensic audit by far, and is no substitute for a full audit of the public debt. In any event, a mere verification by an accountant of three-year-old unaudited financial figures prepared by another firm, will not serve as substitute to the required audited financial statements of the government of Puerto Rico for the last three years, nor validate any so called 'bridge'.
Moreover, it seems almost impossible, for an accounting firm to issue a clean opinion at this stage, based on the significant information listed as missing in the draft Puerto Rico government financial reports, which included substantial undetermined pension liabilities and other missing accounts, as presented by the past administration. Nor would a 'verification' by a forensic accounting firm comply with the requirements for a possible new emission of Puerto Rico debt under current municipal market norms and agency regulations.
The Board has also started to expand their territory in two ways: first, even though it admits that under PROMESA it has no obligation to deal with the island's economic development it now informs that it will 'insert itself' and hold public hearings directed at an economic recovery; second, the Board now informs that it will initiate an effort in Congress regarding health care and Obama health fund increases and extensions for the Island.
Finally, the Board and the new administration appear to be spinning wheels and spending precious and critical time in view of the short automatic stay extension period, trying to recreate what appears to be unavailable financial data, and discussing the traditional mid and long term solutions that have not worked well in the past in other jurisdictions, including: severe austerity measures, new tax impositions and unsupported reliance on expected surplus accumulations to be created by unreal economic growth estimates, in order to pay back a substantial part of the public debt.
They really don't seem able and ready to face the short term cash flow and liquidity crisis that this government and the people of this Island will undoubtedly have to face in terms of a few months.
What's not being considered are the essential elements for a successful private or government insolvency reorganization case. That is, immediate cash flow relief that may be tied into carefully thought out cuts in government expenses at all levels and branches of government, privatization programs and sale of unnecessary assets.
But all of the above require U.S. government initiatives and Congress stepping up to the plate, accepting responsibility and providing the necessary interim financing on an emergency basis, including: short term loans, investment or guarantees from federal agencies, or any sort of hybrid formula that guarantees access to the markets. All of these methods have been used effectively in the past when dealing with private companies, which like the Commonwealth, needed immediate insolvency resolution.