PROMESA and Puerto Rico’s Pathways to Solvency

Facing a self-declared “death spiral” of public debt, the Governor of Puerto Rico announced a debt moratorium earlier this year, halting payments to bondholders. A series of missed payments followed, including a landmark default on constitutionally guaranteed bonds in July. At the same time, Congress passed the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA or “promise” in Spanish), which combines a debt restructuring system with federal controls over the island’s finances. But enacting PROMESA is only a first step. Coordination and engagement with creditors is the next step—and an even more complicated one—in Puerto Rico’s long journey towards solvency and fiscal stability.

Unparalleled Complexity

Puerto Rico’s debt crisis is unparalleled in its legal and financial complexity. For one, Puerto Rico’s debt structure is extraordinarily fragmented. Eighteen different governmental agencies have issued twenty types of bonds, making Puerto Rico’s capital structure far more complicated than that of a typical public or private debtor. Capacity to pay and revenue streams vary greatly among the issuers. Many of these bonds have convoluted and conflicting legal priorities and security interests.

Further, as a quasi-sovereign territory of the United States, Puerto Rico exists in a legal limbo. [1] Neither sovereign nor a state, Puerto Rico lacks the immunities and legal autonomy of a sovereign debtor like Argentina or Greece. But Puerto Rico is also locked out of the municipal debt restructuring system that was available to the City of Detroit and Jefferson County, Alabama. [2]

Distressed Debt Restructurings

In a typical distressed debt restructuring, creditors take a “haircut” and receive new debt instruments in exchange for their existing debt. Voluntary restructuring deals can avoid costly litigation or painful bankruptcy proceedings. Ukraine avoided a default last year through a negotiated restructuring with bondholders for $18 billion in debt. [3] Greece’s preemptive voluntary restructuring in 2012 is another prominent example. These voluntary deals might be far from perfect, but negotiated solutions are almost certainly better than prolonged disputes and creditor litigation.

Last year, there were glimmers of hope for voluntary deals in Puerto Rico’s debt crisis. This past December, the Puerto Rico Electric Power Authority (PREPA) reached a voluntary restructuring agreement for $9 billion in debt. But, aside from the ongoing PREPA restructuring, Puerto Rico’s engagement with creditors has been fitful. After some promising signs early on, a broad group of bondholders known as the Ad Hoc Group of Puerto Rico collapsed. Puerto Rico’s bondholders have been fragmented, unable to coordinate amongst themselves. Lawsuits have poured in as creditors jockey for priority.

Facilitating Debtor-Creditor Coordination

Reaching consensus in sovereign debt restructurings is difficult. Without a global bankruptcy court or financial regulator to mediate disputes or force compromise, holdout problems and inter-creditor conflicts loom large. When debtors and creditors do cooperate, their coordination is fundamentally ad hoc. We argue that the prospects for debtor-creditor cooperation in distressed debt restructurings hinge on a combination of incentives, imperatives, and constraints.

Traditionally, the global sovereign debt market has largely operated in a legal and regulatory vacuum, lacking a bankruptcy system to drive debtor and creditor behavior. Recent years have seen efforts to incentivize or compel debtor-creditor cooperation in sovereign debt through voluntary codes of conduct, model contract terms, and conditional lending policies. However, the legal and political aspects of Puerto Rico’s quasi-sovereign debt crisis rendered coordination uniquely difficult.

Pathways to Solvency under PROMESA

Before PROMESA, Puerto Rico’s legal situation was very uncertain—lost somewhere between full-fledged sovereignty and municipal status. In light of these obstacles, PROMESA aims to create incentives, imperatives, and constraints to nudge Puerto Rico and its creditors towards cooperation. PROMESA’s two-fold restructuring system includes a framework for voluntary debtor-creditor workouts and, if voluntary negotiations fail, a court-supervised process akin to bankruptcy.

PROMESA’s voluntary framework installs a creditor voting system to facilitate restructuring deals. In doing so, PROMESA establishes bond-by-bond voting pools. If a two-thirds majority of creditors within a pool agree to a deal, the terms apply to the entire pool. This majority voting system constrains the ability of dissenting creditors to hold out. Essentially, this measure retrofits Puerto Rico’s bond contracts with collective action clauses, a now-common legal provision in sovereign bond contracts.

In the event that a voluntary agreement cannot be reached, the federal oversight board created under PROMESA can prescribe court-supervised restructuring, effectively compelling the parties to engage. This “debt adjustment” pathway resembles a more traditional insolvency system with judicial supervision and bankruptcy mechanisms. If going to court to restructure looks unpleasant and uncertain enough, parties will be further incentivized to reach voluntary agreements. Meanwhile, PROMESA’s temporary stay on bondholder litigation further constrains the ability of creditors to gum up a restructuring through lawsuits.

The complications and ambiguities of Puerto Rico’s unique legal status required an unprecedented solution. With PROMESA, Congress designed a pathway to solvency for Puerto Rico that inextricably ties its fate to its private creditors. PROMESA is a life raft—far from a perfect vessel. But PROMESA could be good enough to get to shore if Puerto Rico and its creditors finally start rowing in the same direction.

The full article is available for download here.