Restructuring and Due DiligenceThe Front-End of Puerto Rico Debt

Maria de los Angeles Trigo

August 2015

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The ability to make back-end changes to debt contracts is one of the main

objections to an international convention on the restructuring of sovereign

debt.

Creditors do not want the risk of having sovereigns incorporating changes

in the bond documents after they have been issued and traded. Their due

diligence would be very difficult if sovereign issuers could incorporate new

legal doctrines and terms after the debt is issued.

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These “back-end changes” are the biggest objection of Puerto Rico’s

creditors to the government efforts to deal with its debt.

In this presentation, I discuss:

some elements that this international convention could consider,

the importance of front-end regulations, and

how this applies to Puerto Rico.

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The Ad Hoc Committee

The UN Ad Hoc Committee on Sovereign Debt Restructuring was

established pursuant to General Assembly Resolution 69/247 approved on

29 December 2014. It was tasked with elaborating, through

intergovernmental negotiations, a multilateral legal framework for

sovereign debt restructuring processes. “The purpose is to increase the

efficiency, stability and predictability of the international financial system

and to achieve sustained, inclusive and equitable economic growth and

sustainable development.”

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In 28-30 April 2015 the Committee celebrated its second working session.

Richard A. Conn, Jr. gave the keynote address, where he discussed factors

to be considered in the preparation of the framework. Mr Conn has been a

consultant to the World Bank, World Trade Organization and the US

Congress, and is the Managing Partner of Innovate Partners, LLC and of

Conn International Group LLC.

This is a very brief summary of his presentation, which merits watching.

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The Multilateral Framework

The framework would be a UN convention that would facilitate

interactions between private and public parties — although developed

countries don’t seem to agree, since they are not participating in the

works of the Committee.

Sovereign debt is unsecured, and that creditors are private parties who

bought the debt in public markets. However, the boycott to this process

by developed countries doesn’t help in solving the problem of lack of a

mechanism that brings together all parties to restructure debt when

needed.

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Sovereignty Mine

It bears consideration how the framework would affect sovereignty. To

some degree national sovereignty will be affected with a project like this,

which is the reason some countries are not participating in these

discussions.

In addition, why would the US and the UK participate in the preparation of

a multilateral framework for restructuring? The laws and jurisdictions of

these countries are usually the ones chosen in debt contracts, so they will

be the ones most affected if an international convention limits or amends

contract rights.

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The problem is compounded by the reality that sovereign defaults to

external bondholders are quite common. And now, recent developments

in case law have made even more difficult for creditors to reach

agreements for new terms, and to exchange bonds.

The interpretation of the contract was so strict that it penalized

reasonable creditors [this reference is to the Argentina case and the

pari passu holding of Judge Griesa of the US District Court for the

Southern District of New York].

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Approaches

There are three approaches to the framework:

Private: let the market rule;

Statutory: an international convention or a set of rules;

Hybrid: a combination of both.

The most important criteria is that the framework has to be perceived as

fair. Therefore, it is better to start with modest changes, to get countries

and private parties to buy-in the framework. The scope could be expanded

later.

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What to Consider Now

The framework at the beginning should concentrate on procedural and

consensual changes. What can be addressed? Slowness of resolution, lack of

forum, and the effect that delays have on the cost structures of both debtor

and creditor.

The task then is to convince developed countries that it benefits them if the

status quo on sovereign debt restructuring changes.

For example, the status quo provides no defense for systemic contagion.

Developed countries have an interest in avoiding systemic failure because they

don’t want to be continually funding it. In addition, although the IMF is, in

theory, like a fireman, there to just put out a fire, the more the IMF intervenes

increases the chances that it turn into an entrenched participant in the

markets.

Also, procedures are important: note that most bankruptcy regimes are

procedural.

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There could be facilitators for negotiations, but they would not be decision

makers, unless the parties agree that a decision is to be made.

The framework could provide that substantive law for the restructuring

process can be determined by the parties in the forum they choose. It

could be either the law in the debt contract or what they decide at the

time of negotiation.

Mr Conn recommends not focusing on enforcement, since it implies a loss

of sovereignty and some countries will oppose the framework just because

of this issue.

It is important to focus on the private market: to get their input and sell

the solution to them, making sure that it works for them. The participation

of the private market is important, since we need both primary and

secondary debt markets.

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What to Consider Later

The issues of moral hazard, systemic risks, and political risks should be

considered later, since they are the most contentious. Especially since

issues of debt restructuring in geographically or politically important

countries is always political.

Any kind of framework that infringes on the ability of powerful,

developed nations to use the political leverage they want is a non-

starter.

Any substantive provisions in a framework that affect the ability to

make political decisions will not have the support of these

countries: politicians will not have judges limit the decisions they

may make on what they believe are political issues.

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An international bankruptcy court or tribunal could be created after the

framework is in place and has been shown to work. This is a complicated

endeavor: it may be a problem to figure out the location of the court, who

the judges will be, and the court’s jurisdiction. The judges also need to

know what are the goals of the court, and what are the tasks given to it by

the legislation. What would be the goals: protect the debtor nation? The

liquidity of the bonds? Protect the economy of the country?

Another issue is the applicable law. The tribunal will be brand new, so

there will be no precedent to guide the parties. That is an important factor

to consider, since in these circumstances it is difficult for lawyers to advise

their clients.

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The more substantive criteria are included in a framework, the more

difficult it will be for parties to agree that it is fair. Conversely, the less

substantive provisions included in a framework, the better, since you leave

it to the participants to determine what they want. This would take care of

one of the objections of the private sector, which is that a substantive

framework would not let them contract freely.

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Front-End Regulations

Restructuring debt is back-ended, and it would be better if there was some

sort of front-end process. This could be done with regulation, especially in

sovereign debt, where a contractual deal has significant effects outside of the

parties. The regulation will recognize that the private contract between

creditor and sovereign has a systemic risk.

The developed nations have a common interest with developing nations in the

front-end: narrow consensual regulations at the start of a transaction. For

example, collective action clauses could be included in the regulation, with a

provision that all sovereign debt contracts will include them. With these

regulations in place before the transaction is entered into, creditors know what

the conditions are when they decide to do business. A small number of these

front-end regulations could have a chance of being included in the regulation.

One of the biggest worries of developed countries is that a court will change

contract provisions after they have been signed.

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Puerto Rico Debt and the Front-End

How do Mr Conn’s remarks apply to Puerto Rico?

The main objection presented by Puerto Rico’s biggest creditors to its

attempts to deal with its debt is the back-end argument. They argue that

Puerto Rico is changing the rules of the game after they bought their debt.

The objection is, especially as to Act 71-2014 (the Recovery Act) and the

H.R. 870 (the Puerto Rico Chapter 9 Uniformity Act of 2015), that creditors

bought the debt believing no bankruptcy or debt restructuring was

available for Puerto Rico.

There is not much strength to this argument of a back-end change to the

contractual provisions. In this case, the argument shows lack of due

diligence on the applicable law (Puerto Rico) and how the law has been

interpreted for decades.

Even the US Constitution permits the renegotiation of contractual

terms and obligations under extraordinary circumstances.

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The majority (over 95%) of Puerto Rico’s debt was issued under Puerto

Rico law. Claims can be brought in a court of competent jurisdiction. This

is the applicable law and jurisdiction, as established in the debt

documents.

Some claims must be presented exclusively in the Puerto Rico

Superior Court in San Juan, such as those related to debt issued by

the Government Development Bank for Puerto Rico.

Before buying any debt, you would expect buyers to study the law

applicable to the transaction, and decide if they are willing and able to live

with its provisions.

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The Need for Due Diligence

With adequate due diligence, buyers would have known that:

Puerto Rico has not renounced its sovereign immunity;

its property is not available to be attached for the payment of debt,

since it is needed for the provision of public services;

it has no property outside of its borders;

the rebus sic stantibus doctrine which, if proven to a court’s

satisfaction, would imply the modification of a contract because of

extraordinary circumstances (and which courts apply in compliance

with the Contract Clause of the US Constitution).

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some creditors are contractually bound to bring their claims in the

Puerto Rico Superior Court in San Juan;

the rest of the creditors must bring their claims in a court of

competent jurisdiction;

there are strong arguments for the abstention of the federal court

in a claim brought under the debt documents — wherever the

federal court may be located;

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These provisions are not back-ended: they are established legal doctrines

in Puerto Rico. They are known to those familiar with Puerto Rico law, and

are identified as a risk by buyers.

The Recovery Act was actually an alternative to the application of the

rebus sic stantibus doctrine. Act 71-2014 established a process that limited

the judge’s discretion, and tried to create an alternative that was familiar

to the recent buyers of Puerto Rico debt.

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Act 71-2014 is no longer available, but the transactions are still ruled by

and interpreted under Puerto Rico law. Creditors should make sure they

have identified all public policy and contract arguments and defenses.

Also, Puerto Rico government structure is unlike any in the US (or the

sovereign debt market, for that matter), so it behooves creditors to

understand it well.

Ignoring the intricacies of applicable law doesn't mean the debtor is

making back-end changes.

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Extras

The video for Mr Conn’s keynote speech can be found here.

Mr Conn’s presentation can be downloaded here.

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Originally published in LinkedIn

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This presentation has been edited from the original post.

Maria de los Angeles Trigo, an attorney and certified public accountant, helps clients understand Puerto Rico’s public finance market. She advises financial institutions, investors, law firms, and government institutions on Puerto Rico debt’s legal and regulatory framework. Maria de los Angeles worked for 16 years in the Government Development Bank for Puerto Rico and was the highest-ranking career legal officer as Director of the Compliance Department and Acting Deputy Director of the Legal Division.

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