Puerto Rico Bankruptcy Puts Pressure on California, Illinois, Connecticut

Puerto Rico protest (Spencer Platt / Getty)
Spencer Platt / Getty

Puerto Rico’s world-record $116 billion bankruptcy filing represents a massive liability risk for auditors who will likely demand that highly-indebted states — such as Connecticut, Illinois and California — disclose more liabilities, write down assets, and curtail debt issues.

Puerto Rico’s congressionally mandated PROMESA financial oversight board filed for Title III bankruptcy-type protection from creditors in the United States Court for the District of Puerto Rico in the early morning of May 3. The filing is the largest municipal bond bankruptcy in history, and America’s third largest bankruptcy, behind only the $691 billion filing by Lehman Brothers and the $328 billion bankruptcy of Washington Mutual.

Breitbart News reported that “vulture” capitalists who bought Puerto Rico bonds for pennies-on the-dollar were trying to court liens on the government’s assets after refusing to take discounts from face value of 77 cents-on-the-dollar for their general obligation bonds, and 58 cents-on-the-dollar for “Cofina” sales-tax-backed debt, offered by Puerto Rico’s Democrat Governor Ricardo Rossello.

Wall Street investment banks issued hundreds of Puerto Rico municipal bonds to take advantage of the triple feature that made the Caribbean Island’s debt exempt from federal, state, and local taxes, regardless of where the bond holder resided. Major underwriters included Citicorp, Bank of America Merrill Lynch, Barclays PLC, Morgan Stanley, RBC Capital, Wells Fargo, JP Morgan, Goldman Sachs, UBS and Lehman Brothers.

Caribbean Business reported in September 2016 that the Federal Bureau of Investigations (FBI) had allegedly requested documents from bond underwriters as part of a probe into a $3.5 billion general-obligation bond issue of 2014, and a $600 million Puerto Rico Electric Power Authority bond issue in 2013.

Despite long-term Puerto Rico municipal bonds having already been downgraded by Moody’s to junk status, Barclays, Morgan Stanley and RBC Capital Markets sold the 2014 bonds at a cost to Puerto Rico of 8.727 percent.

The Commonwealth has been late in issuing its fiscal year-end financial statement by October 31 every year since 2,000. The U.S. territory set a record in 2014, according to Bloomberg News, by being 181 days late. Each failure was a violation of the Securities and Exchange Commission rule requiring municipal-bond issuers to file audited annual reports in a timely manner.

The legislature’s Puerto Rico Commission for the Comprehensive Audit of the Public Credit issued a report in June 2016 that concluded that because Puerto Rico’s constitution specifically states that the territory’s budget must be balanced, at least $4.7 billion in island bonds sold by Wall Street bank syndicates to finance deficits and to pay interest and principal on older debt may be illegal.

According to the Justia Supreme Court blog, the 1885 case of City of Litchfield v. Ballou established that a “constitutional provision forbidding a municipality from borrowing money operates equally to prevent moneys loaned to it in violation of this provision.” The Court ruled that an illegal loan made collecting on municipal bonds was unenforceable.

Creditors in Detroit’s $19 billion bankruptcy lost $1.2 billion in an out-of-court settlement due to the city and its underwriters skirting the debt limit to sell bonds.

The turmoil, and potential misdeeds, in Puerto Rico are sure to put pressure on auditors in other states and municipalities to demand greater transparency regarding financial statements, and to take bigger reserves and write-offs on their balance sheets.

The Connecticut State Controller’s Office reported on May 2 that state income tax collections plummeted again in April, leaving the state in crisis with a $5.2 billion deficit over the next two fiscal years. With a state spending plan of $28.62 billion for 2016-17, the Controller’s latest estimate predicts revenues down by about $413 million this fiscal year, down another $597 million in 2018, and down another $865 million in 2019.

Breitbart News reported in January that California would face its first deficit since 2012, after Governor Jerry Brown admitted the state expected a $1.6-billion deficit, despite record tax collection.

Crain’s Business reported in March that the Illinois general funds budget deficit was $9.6 billion in fiscal 2016, an increase of $2.7 billion from the previous year, and the biggest deficit in at least 10 years.

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