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J uly 08, 2014

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Law of Corporate Finance
Infrastructure Projects

The Economist, July 05-12, 2014
Neither a state nor independent | How a territory falls between bankruptcy regimes
PUERTO RICO has put on a brave face during its year-long debt crisis. But on J une 28th Alejandro Garca
Padilla, the governor, made a belated concession to reality by signing a law establishing a de facto
bankruptcy regime for state-owned enterprises. With the Puerto Rico Electric Power Authority (PREPA), a
cash-strapped utility, teetering on the brink of default, the new system may face its first test soon.
Puerto Ricos woes stem from a mix of structural weaknesses, external shocks and self-inflicted wounds.
As an overseas American territory, it uses the dollar and the national minimum wage. That makes labour
costly and exports uncompetitive. From 1976-2006 firms on the island were exempt from federal tax on
their local profits. But once that carve-out expired, the economy fell into an
eight-year recession. And after Detroit went bankrupt, investors fled risky
municipal bonds, which raised Puerto Ricos financing costs.
However, the government also bears its own share of the blame. It has spent
too little on infrastructure and too much on pensions. And it has grossly
mismanaged PREPA, which still generates 65% of its power using expensive
fuel oil. Not only did the company cost the state $276m in 2013 but its high
prices serve as a tax on most economic activity. Mr Garca Padilla has tried to
compensate with austerity: on J uly 1st he signed a balanced budget that cut
discretionary spending by 8%. But Puerto Ricos public finances have
regularly underperformed official forecasts.
The government insists that it cannot default, because its constitution gives debt payments first priority.
However, this only applies to its general-obligation and guaranteed bonds. The remaining public debt is
backed by specific revenues like highway tolls or, in PREPAs case, electric bills. And the $800m of bank
credit lines PREPA uses to buy fuel come due in August. Unless it can renegotiate quickly, it will either
default or turn out the lights.
No one knows what would happen then. Puerto Rican state agencies fall in a gap in Americas bankruptcy
code: they are excluded from the regimes both for local governments and private firms. As a result, missed
payments would probably set off a whirlwind of litigation. To forestall this risk, the government instituted a
new insolvency system for its companies. It gives them nine months to negotiate a settlement acceptable to
holders of 75% of their debt. If the parties cannot agree, local courts would impose a solution. Investors
saw the law as evidence that PREPA was set to restructure its $8.6 billion of liabilities, and have dumped
its bonds.
But PREPAs two biggest creditors, the mutual-fund firms Franklin Templeton and OppenheimerFunds,
have challenged the law, arguing that the constitution gives Congress exclusive control over bankruptcy. If
they win, it might boost calls to change Puerto Ricos status. As the 51st state, its state-owned firms would
be covered by the federal bankruptcy code. As an independent country, it could set its own rules. Under the
status quo it may be stuck with neither.
(emphasis added)
Visit Puerto Rico and lose your shirt