The official Puerto Rico Oversight Board report on the territory’s debt recommended changes in budgeting, rating and bond issuance practices, but said it was generally too late to punish anyone over the sale of debt that led to the biggest municipal default.
The Oversight Board released the 608 page report on Monday evening, almost a year after hiring Kobre & Kim to do the research and create it, consistent with a requirement of the Puerto Rico Oversight, Management, and Economic Stability Act. Board Members Arthur González, Ana Matosantos, and David Skeel oversaw the process.
“I only had a chance to read the executive summary of the report but I agree with the findings,” said Howard Cure, Evercore Wealth Management director of municipal research. “After the tax credit phase-out in 2006 there were no real plans to stimulate the economy, balance the budget or fund the pension system. I think the problems were also compounded by the national recession and then later, the hurricane damage.
“There is a need to have the federal government help to craft tax benefits to provide more self-sustaining growth in Puerto Rico,” Cure continued. “However, without voting representation in Congress, it is hard to imagine that the commonwealth will get special tax treatment.”
The report said that in addition to measures being pursued by the board, the branches of Puerto Rico’s government should adopt budgets that better estimate the impact of tax credits on revenues and include component units along with the General Fund. The local government should continue transitioning to a Generally Accepted Accounting Principles budget. The government should update financial reporting information throughout the year using the accrual basis method.
The local government should adopt an accounting and budgeting system that is uniformly implanted in all parts of Puerto Rico’s government, including its public corporations.
The report said Kobre & Kim found no evidence that the “original purpose of COFINA [the Puerto Rico Sales Tax Financing Corp.] was to evade the [Puerto Rico] constitutional debt limit.” However, the constitution should be amended to so that this sort of debt counts towards the constitutional debt limit.
Concerning the public utilities, the report said that if they are to remain public entities their boards should be altered to be a mix of independent and governor-appointed members. The members should have longer terms and terms staggered across administrations. The boards should create audit committees of their members. The committees should exclude uncollected revenues from rate covenant calculations.
Further, the report says that the utilities should be required to disclose their use of bond proceeds. It noted that from 2010 to 2013 there was a several hundred million dollar discrepancy between what Puerto Rico Electric Power Authority bond proceeds were supposed to be used for and what they were actually used for.
There should be independent rate boards for both the utilities and these boards should make regular and predictable changes to the rates. Finally with regard to the utilities, an independent fiscal agent should be empowered to implement the public utilities’ respective fiscal oversight agreements “in a way that requires compliance with rate covenants.”
The U.S. Congress extended the Investment Company Act of 1940 to Puerto Rico in 2016. This act requires mutual funds to follow disclosure requirements, borrowing limitations, and regulations concerning transactions with affiliates. The report says that federal regulators and lawmakers “critically evaluate any request for a ‘grandfather clause’ that would exempt existing local closed ended funds suffered.”
Puerto Rico’s politicians and regulators should consider “banning affiliated brokers and financial advisors from selling affiliated products.”
The report raises questions about the long-standing “issuer-pay” model for municipal credit ratings and recommends Congress reconsider its statutory bar against the regulation of credit rating agencies’ criteria and methodologies.
The report said, “Our investigation revealed two primary weaknesses in how the [credit rating agencies] developed their rating actions during the relevant period. First, the issuers had the power to frame the ratings analysis; and second, the ratings largely resulted from discretion and individual perception as to what weight, if any, to give certain information that, in the context of Puerto Rico-Related bond[s], should have had heightened significance. This includes, among other things, forward-looking projections, Puerto Rico’s vulnerability to and the economic impact of hurricanes, the actual use of bond proceeds, and the impact of a CRA’s own ratings downgrade.”
While the ratings agencies appear to have genuinely believed that their ratings were justified at the time, the wide latitude that the agencies and their analysts had with respect to ratings criteria resulted in Puerto Rico Bonds having been rated above investment-grade despite abundant evidence that they shouldn’t have been.
The report made a series of recommendations, among them that the “agencies have their in-house attorneys or outside counsel analyze the soundness of any legal opinion supplied by or on behalf of an issuer.”
Responding to the report, Fitch Ratings issued a statement: “Fitch stands by its rating opinion, which, over time, reflected Fitch’s opinion of the issuers’ ongoing credit deterioration. As the report points out, Fitch adhered to its criteria when assigning its ratings to the Puerto Rico-related bonds and its analysts believed Fitch’s rating actions to be appropriate in light of the relevant circumstances.” Moody’s Investors Service and S&P Global Ratings declined to comment on the report.
On a different topic, the report recommends that Puerto Rico develop a way for courts to review future bonds before they are issued, thus assuring the bonds’ legality.
In a nearly 100 page section the report lays out numerous ways Puerto Rico’s bonds and the steps that led to their issuance may have run afoul of existing laws and regulations. However, it says that there are laws that bar either private investor actions under U.S. securities law or SEC enforcement actions when more than five years have passed since the issuance of the securities.
At this point this includes nearly all Puerto Rico’s bonds except for the 2014 general obligation bond, and the SEC has said, after completing its own investigation, that it won’t be taking enforcement action on this bond.
There have been ongoing and frequently successful actions taken against firms that sold closed ended funds holding large amounts of Puerto Rico bonds to on-island investors. These have been filed at least as early as 2011.
The report criticizes Banco Popular for participating as underwriter in the 2014 GO bond. It notes that Banco Popular and Citi both advised the Government Development Bank for Puerto Rico against a long-term GO bond. The firms said Puerto Rico should seek $2 billion in “liquidity improvements” through securitizing property-tax and sales-tax based municipal loans. They also called for fiscal remediation measures and the establishment of a five-member government oversight body that would include members from the Federal Reserve, U.S. Treasury, and someone from the bond market community.
When Puerto Rico chose to sell the GO, Citi chose not to be an underwriter. Banco Popular did participate. An “unjust enrichment claim” could be considered against Popular, the report said.
Responding to the report, Banco Popular released a statement: “Popular Securities, Popular, Inc. and Banco Popular (“Popular”) are currently reviewing in depth the extensive report issued last night by Kobre & Kim.… Popular… acknowledges that the report includes certain references to actions by Popular and others. Popular is studying the matter closely and will not publicly comment on the specifics of the report’s findings concerning Popular in view of ongoing and potential related court proceedings.”
Lynn Hume contributed to this story.
