The ruling is a significant setback for the Puerto Rico government, which has been engaged in a high-wire act — trying to restructure the debts of its public corporations while still maintaining the confidence of the municipal bond market that it needs to keep financing its operations.
“This is a victory for the rule of law,” said Laurence L. Gottlieb, chairman and chief executive of Fundamental Advisors...
“But now the question is what’s next in terms of dealing with Prepa’s debt.”
...
“Who are they going to sell to?” asked Tom Metzold, a senior portfolio adviser at Eaton Vance, an investment company that has sold most of its Puerto Rico holdings. “Bondholders want to know what their rights and remedies are. There is no clarity about that at all.”
“I think now everything is on the table,” said Mr. Donahue.
Investors in billions of dollars of Puerto Rico bonds secured a major legal victory when a federal judge ruled that the commonwealth’s recently enacted debt-restructuring law was unconstitutional.
In the decision Friday night, Judge Francisco A. Besosa of the United States District Court in Puerto Rico said the Puerto Rico Public Corporations Debt Enforcement and Recovery Act was void and enjoined commonwealth officials from enforcing it.
The recovery act was passed by Puerto Rico lawmakers last summer to enable the commonwealth to overhaul the debts and labor contracts of the island’s struggling public corporations, including the Puerto Rico Electric Power Authority, which is known by its acronym, Prepa.
Like states, Puerto Rico cannot seek protection from creditors under federal bankruptcy law, leaving the commonwealth with few ways to straighten out the finances of troubled agencies like Prepa, which supplies electricity to the island’s roughly 3.6 million people.
A group of Prepa bond holders, including BlueMountain Capital and OppenheimerFunds, that own about $2 billion of the power’s authority’s debt sued the commonwealth in federal court, arguing that the recovery act violated their contractual rights.
The ruling is “a major victory for municipal bondholders,” Amy Caton, a lawyer for Oppenheimer and Franklin Mutual, another Prepa investor, said in a statement.
The passage of the recovery act in June rattled investors, particularly hedge funds, which had been buying up bonds issued by Prepa and other Puerto Rico entities at distressed prices. Investors feared that the new law showed how the government of Puerto Rico was willing to unilaterally change the rules, without warning.
The law spawned a spate of downgrades by the ratings firm Moody’s, which had already rated the commonwealth’s debt as junk.
On Friday, Judge Besosa denied the commonwealth’s motion to dismiss the investors’ lawsuit, saying that the recovery act was pre-empted by federal bankruptcy law.
“The commonwealth defendants, and their successors in office, are permanently enjoined from enforcing the recovery act,” he wrote in a 75-page decision.
A spokesman for the Government Development Bank, which oversees the commonwealth’s debt deals, said: “We will be reviewing all the aspects of the ruling rendered by Judge Francisco Besosa. In due time and after careful examination, we will decide on a course of action.”
The ruling is a significant setback for the Puerto Rico government, which has been engaged in a high-wire act — trying to restructure the debts of its public corporations while still maintaining the confidence of the municipal bond market that it needs to keep financing its operations.
The recovery act allows for the revamping of debts at certain public corporations. But it does not apply to the commonwealth’s general obligation bonds.
Prepa is mired in about $9 billion in municipal bond and other debt and has been struggling with high fuel costs, though the drop in oil prices has relieved some of that strain.
“This is a victory for the rule of law,” said Laurence L. Gottlieb, chairman and chief executive of Fundamental Advisors, a hedge fund and private equity firm with investments in Puerto Rico debt. “But now the question is what’s next in terms of dealing with Prepa’s debt.”
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Critical elements of Puerto Rico’s plan to avert financial disaster are in jeopardy, after a federal judge struck down a law that allowed the government to restructure certain debts.
The law, known as the Recovery Act, was meant to give Puerto Rico’s public corporations protections similar to bankruptcy. Unlike American cities like Detroit, which used federal bankruptcy law to sort out its finances, Puerto Rico, a United States commonwealth, is not permitted to declare bankruptcy.
In his decision on Friday night, Judge Francisco A. Besosa of the United States District Court in San Juan, Puerto Rico, said the Recovery Act overstepped federal law, and he enjoined commonwealth officials from enforcing it. The government said on Monday that it planned to appeal the judge’s ruling.
Without the Recovery Act, government officials worry that attempts to gain concessions from creditors and unions at public corporations like the deeply indebted Puerto Rico Electric Power Authority will dissolve into chaos.
The court ruling frightened some investors, who worry that the island is running out of ways to escape its basic predicament: tens of billions of dollars in debt and a stagnant economy.
Prices on Puerto Rico general obligation bonds dropped on Monday, the first trading day after the court ruling. Yields on a $3.5 billion bond that the commonwealth issued last March traded as high as 10.23 percent, topping yields on similar Greek bonds — suggesting that Puerto Rico is at greater risk of default.
The plunging prices could complicate Puerto Rico’s plans to sell roughly $2 billion in new bonds in the coming months — money the island of 3.6 million people needs to repay previous debts.
“Who are they going to sell to?” asked Tom Metzold, a senior portfolio adviser at Eaton Vance, an investment company that has sold most of its Puerto Rico holdings. “Bondholders want to know what their rights and remedies are. There is no clarity about that at all.”
Puerto Rican officials — backed by hedge funds that own billions of dollars of the island’s debt — are turning to Washington for help. Puerto Rico’s resident commissioner to Congress, Pedro Pierluisi, said he planned to push for federal legislation this week that would allow the commonwealth to approve bankruptcy filings by its municipalities and public corporations. The commonwealth itself could not file for bankruptcy under the proposed law, he said.
Mr. Pierluisi said he met Monday afternoon with a group of about 20 executives from hedge funds and private equity firms in New York to brief them on his effort to create a bankruptcy statute. Earlier on Monday, he discussed his proposal with ratings firms.
“You simply do not want to have a default,” Mr. Pierluisi said. “You need to have some structure.”
The legal turmoil is also testing the big bet by many of Wall Street’s largest hedge funds and private equity firms that have barreled into the commonwealth’s bonds and now own an estimated 25 percent of Puerto Rico debt. Funds including Fir Tree Partners and Centerbridge Partners are leading a group of investment firms, known as the Ad Hoc Group, that months ago expressed its willingness to offer the commonwealth financing options.
In some cases, there are signs that the hedge funds’ reach for big profits may be faltering or at least delayed.
Hedge funds were big buyers of the commonwealth’s bond deal in March, which originally sold at 93 cents on the dollar. On Monday, that price fell to as low as 81 cents on the dollar. The high interest rates that the bonds pay have softened the hedge funds’ losses somewhat. But their investment is becoming increasingly complicated.
Some hedge funds are planning to double down and invest in the new bond deal, according to people briefed on the mater. The bond would probably be backed by revenues from a tax on petroleum, though investors are looking for the government to offer additional sweeteners like a provision that would tie the pledged revenue to inflation.
Many of the hedge funds that own Puerto Rico debt are seasoned investors in distressed situations that have profited by buying, for example, debt issued by Greece, a country that has possibly faced even bigger challenges than Puerto Rico.
Broadly, the hedge funds appear to expect that the new bond deal will buy Puerto Rico more time to overhaul its tax system. Once revenues start to perk up, the bonds should gain in value. Puerto Rico and its bond investors have applied a similar logic for years, viewing each new bond deal as a temporary fix. But with each deal, the commonwealth and its public corporations have sunk deeper in debt.
The Recovery Act was meant to give added protections to holders of Puerto Rico’s general obligation debt by limiting restructurings to a handful of public corporations. But political pressure is growing for the government to spread the financial pain to all debt holders — not just investors in the public corporation debt, said Robert Donahue, a managing director at Municipal Market Analytics.
“I think now everything is on the table,” said Mr. Donahue.
Officials at the Government Development Bank, which oversees the commonwealth’s debt deals, have said that the general obligation pledge remains sacrosanct.
“We view the court’s decision as a temporary setback, and we will pursue all remedies available to continue to operate in the best interests of all our constituents and public interests,” the bank’s president, Melba Acosta Febo, said in a statement.
