Puerto Rico considers simple solution to debt crisis: Don’t pay

In "The Puerto Rico Gamble," Fault Lines travels to San Juan as protests erupt over the island’s crippling debt crisis and Wall Street’s growing influence on its economy. The film airs on Sunday, Oct. 25, at 9 p.m. Eastern time/6 p.m. Pacific on Al Jazeera America. | Click here to find Al Jazeera in your area.

While Puerto Rican leaders look for ways to address the island’s $72 billion debt, some say the solution may be simple: Don’t pay it.

A small group of Puerto Rican lawmakers is pushing the idea that significant portions of Puerto Rico’s debt may in fact be unconstitutional.

Manuel Natal, one of the legislators behind the effort, claims that up to 75 percent of what the island owes could be voided in court.

“If debt was issued in violation of the constitution that debt is illegal and subsequently should not be paid,” said Natal. “It should be put aside, because in legal terms, it’s like it never happened.”

This strategy, called “debt nullification,” has been used elsewhere in the U.S. to address fiscal crises. But in Puerto Rico's case, it all but promises a legal showdown with Wall Street hedge funds that own a significant portion of the island’s debt — investors that the government is now trying to bargain with.

While Puerto Rico Governor Alejandro García Padilla has acknowledged that debt found to be unconstitutional should not be repaid, his administration has tried nearly every other option so far.

After the White House quickly dismissed talk of a federal bailout, Puerto Rico’s government, and its congressional representative Luis Pierlusi, have pushed a bill to allow the U.S. territory access to bankruptcy proceedings. That bill has stalled in the Congress. Meanwhile, talks with a group of hedge funds were suspended.

The gridlock over Puerto Rico’s fiscal crisis has led many to wish the debt would simply disappear.

Now, that might actually be possible.

Natal says the Puerto Rican Constitution limits annual debt payments to 15 percent of total revenues. But a report released in September by the governor’s fiscal team projects that in 2016, the government will spend up to 42 percent of its revenues on debt — meaning the island’s debt payments would approach nearly three times the constitutional limit.

So how was the Puerto Rican government able to continue borrowing in excess of what its constitution allows?

Part of the answer lies in the island’s 2006 budget crisis, when Puerto Rico’s two main parties — the Popular Democratic Party and the New Progressive Party — broke a deadlock over how to solve a $1 billion budget shortfall with a bipartisan agreement to create desperately needed revenue through a new 7 percent sales tax.

The revenues of that tax went to a third party corporation known as the Puerto Rico Urgent Interest Fund Corporation (COFINA), which used a portion of the proceeds to make new loan payments.

“It’s quite obvious that COFINA was a mechanism created to circumvent the debt limitation,” said Natal.

The vote to establish COFINA was nearly unanimous. Luis Torres Cruz, a member of the Popular Democratic Party, voted yes, but with a warning that the government was in the process of “causing a structural deficit, but also a high level of debt.” This, he said, was threatening to “put the fiscal burden onto future generations, inconsistent with our constitution.”

Nearly a decade later, COFINA’s borrowing power has been expanded to constitute some $15 billion of Puerto Rico’s $72 billion debt — nearly a fifth of its stated debt burden.

“All told, COFINA is legally suspect at best,” wrote David R. Martin, a Georgia-based attorney and author of the book “Puerto Rico: The Economic Rescue Manual,” in a September editorial for The Hill.

Martin told “Fault Lines” that while Puerto Rico tried to spin off debt to avoid violating its constitution, the law establishing COFINA also promised creditors that the bonds came with the government's promise of payment.

“This legislative assurance that bondholders will never be deprived of an amount sufficient to repay their bonds means that those payments should count toward the debt limit,” he said.

Ultimately, these claims would have to be tested in court, foreshadowing a legal showdown with some of the most powerful forces on Wall Street.

But it wouldn’t be the first time. Proponents of the debt nullification strategy point to Detroit as a legal precedent of sorts.

In the midst of Detroit’s efforts to restructure its debts after declaring bankruptcy in 2013, lawyers for the city sued several so-called service corporations that former Mayor Kwame Kilpatrick had established in 2005 to help fund the city’s pensions.

In short, the city skirted its debt limit by taking out $1.5 billion in new loans through a third-party corporation that was, nonetheless, funded by payments from city coffers.

The strategy appeared to work and was even celebrated.

Bond Buyer magazine gave Mayor Kilpatrick an award for the innovative deal, lauding the mayor’s ability to “shift the burden of unfunded pension costs from the city to service corporations” and in the process “meet the legal requirements for the city's debt limits.”

But all of that fell apart in court in 2013.

Looking to reduce its debt payments, the city’s lawyers filed suit against the service corporations, calling them a “sham” and arguing that Kilpatrick’s much-lauded deal was actually “illegal, void, and of no effect whatsoever.”

The city’s lawyers also cited an 1895 U.S. Supreme Court ruling, Litchfield v. Ballou, where judges ruled against a creditor seeking payment. Because Litchfield, a municipality in Illinois, had originally sold the bonds in violation of its legal debt limit, the ruling said, the city did not have to pay that debt.

More than 100 years later, the argument appears to have worked in Detroit as well. Creditors settled out of court, losing 87 percent of the money they were owed, and saving the city some $1.2 billion.

The judge in that case, Steven Rhodes, is now an adviser to the government of Puerto Rico. In October, Rhodes said that Detroit’s debt nullification strategy had worked, according to the Puerto Rican newspaper El Nuevo Dia.

At a hearing of the Senate Committee on Energy and Natural Resources on Thursday, Vermont Democrat and presidential candidate Bernie Sanders took a break from the campaign trail to question Governor García about the situation in Puerto Rico.

“There is a human tragedy unfolding, and in my view, Wall Street should not be believing that they can draw blood from a stone,” Sanders said.