Puerto Rico risks creditor ire by hijacking money earmarked for bond payments

Puerto Rico may have dodged a bullet when it avoided default last week, but its decision to commandeer revenue that was supposed to meet future debt payments will invite creditor pushback and possibly lawsuits.

Creditors have long criticized Puerto Rico’s spending habits, and may have the ammunition to bring those complaints to court now that the Caribbean island plans to divert funds to cover constitutionally-guaranteed debt and essential government services.

The US territory, which owes creditors $72 billion, last Tuesday avoided defaulting on a $355 million payment. But it owes another such payment on Jan. 1, which can only be made if revenue that was earmarked to repay and service other debt owed by various government agencies is repurposed, Governor Alejandro Garcia Padilla said. The island said it also needs to use that revenue to keep some key services operating, though it has not specified which ones. Many creditors said these so-called clawbacks are premature, and question whether they will be used on truly essential services.

The government hasn’t been specific about the revenue that will be grabbed. Bonds vulnerable to the switch include $4.6 billion at Puerto Rico’s highway authority (HTA), $1.9 billion at its infrastructure authority (PRIFA), and additional debt at a public transportation authority and convention center authority, according to an executive order signed by Garcia Padilla.

One creditor source with exposure at the affected agencies said a lawsuit was possible, insisting that clawbacks were being misused under Puerto Rico’s laws and constitution. “They haven’t met the requirements to permit a clawback under the constitution … you can assume we’re looking at all the different avenues,” said the source. Two other sources said that, while lawsuits are an option, they were more inclined to wait to preserve their negotiating ability.

“There is a very high probability of protracted litigation,” said Ted Hampton, vice president at Moody’s Investors Service. “It’s a bit like a race or some kind of competition – people are waiting to jump in when the whistle blows.”

Hampton said he expected creditors would at least consider legal action over the clawbacks.

Puerto Rican officials have themselves acknowledged the potential for lawsuits. Justice Secretary Cesar Miranda said last week that the clawbacks could open the door to litigation because they “could be interpreted as a technical default, in the way that we retain money destined to eventually pay a debt when due.”

Creditors’ frustration is likely to only increase in the next few weeks. For example, the island by December 20 owes $120 million in Christmas bonuses for public sector workers, which are a legal requirement in Puerto Rico. Paying them at the expense of bonds would likely irk creditors, yet skipping them would outrage labor unions.

Exactly how the diverted cash is spent will invite investor scrutiny.

A 1980 law in Puerto Rico dictates that any clawbacks should be used first to pay constitutionally backed debt, and then to fund essential services. Puerto Rican officials suggested they plan to use them for both purposes at once.

“There is little question that (the clawbacks) are a patent attempt to revise the provisions of the constitution, legislation and contracts without justification or required process,” said Nader Tavakoli, interim president and chief executive officer of Ambac Financial , which insures about $1.1 billion principal of bonds at the affected agencies. A lawsuit could also challenge the type of services being funded, especially if they include what creditors may claim are discretionary items like Christmas bonuses.

Still, creditors wary of litigation say they want to be careful not to hurt progress in ongoing talks with the island on a consensual debt restructuring agreement. “We implore the governor to get back to the negotiating table toward consensual solutions, which are achievable,” Tavakoli added.

Puerto Rico has said it wants to structure a universal exchange offer, or “superbond,” for creditors across many different debt classes. Litigation would make that process more difficult, said several creditor sources, threatening the anticipated high ratings of new debt that could attract creditors to an exchange offer in the first place.

If creditors can help the island to make its January payment without clawbacks, litigation may be avoided. Its next major maturity date is in May, when $422.8 million is owed on senior Government Development Bank notes, according to a source familiar with the situation. That allows more time to talk, free from the pressure of looming defaults.

An offer by at least two bond insurers to provide a bridge loan to get Puerto Rico through January remains on the table, said two sources close to the talks.

A lawsuit at this stage may not succeed. Without a missed payment, clawbacks alone might not convince a court of Puerto Rico’s wrongdoing, said Height Securities Puerto Rico analyst Daniel Hanson. Creditors may fare better if they delay litigation until an actual default.

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