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Testimony 

NTU President Comments to the House Committee on Natural Resources Regarding Puerto Rico’s Fiscal Oversight, Economic Growth, and Financial Stability

by Pete Sepp / /

Comments of Pete Sepp, President, National Taxpayers Union
to the Committee on Natural Resources, U.S. House of Representatives
Regarding Puerto Rico’s Fiscal Oversight, Economic Growth, and Financial Stability

Introduction

Chairman Bishop, Ranking Member Grijalva, and Members of the Committee, I am pleased to offer the following comments on behalf of National Taxpayers Union (NTU) following the Subcommittee on Indian, Insular, and Alaska Native Affairs’ February 2nd hearing entitled, “The Need for the Establishment of a Puerto Rico Financial Stability and Economic Growth Authority.” I also hope these comments will be useful to the Committee for this today's hearing, entitled “The U.S. Department of the Treasury’s Analysis of the Situation in Puerto Rico.” Our members across the United States, including those residing in the Commonwealth of Puerto Rico, deeply appreciate the thoughtful manner in which the Committee has sought the views of so many individuals and organizations interested in the future of the island and its taxpayers.

As you may know, throughout its 47-year history NTU has held an abiding concern for the fiscal well-being of all U.S. jurisdictions. We humbly offer to the Committee all our resources as you continue your vital deliberations. To this end I first commend your attention to several communications (from February 27th, 2015, from July 8th, 2015, and from December 1st, 2015) NTU has distributed on issues surrounding Puerto Rico’s finances, along with an October 9th, 2015 legislative memorandum available online discussing numerous issues.

In this document, however, I wish to concentrate NTU’s remarks upon several matters raised in recent hearings, as well as items the Committee may find valuable for consideration as the House attempts to craft an actionable legislative package for Puerto Rico’s finances by next month.

I. Oversight and Stabilization

NTU’s 2015 memorandum offered advice on how Congress and Puerto Rico’s officials should design policies that will support financial transparency, more effective management of taxpayer funds, and greater fiscal discipline going forward. I particularly wish to direct your attention to the memorandum’s discussion of constitutional tax and expenditure limitations. Here I will review a smaller number of items involving the mechanics of near-term reforms.

1) Balance the Powers and Composition of the Oversight Entity. Nearly all of the witnesses appearing before the Committee on February 2nd proposed some type of control board, financial stability authority, or other body to assist Puerto Rico’s fiscal transformation. Opinions varied, however, on how such a body should be constituted and how it should operate. NTU will term this body the “oversight entity.”

Aside from the guidance NTU has already offered, we would agree with former Mayor Williams’ practical recommendations that an oversight entity be composed of a manageable number (five to seven) of individuals with solid financial experience, backed by a capable staff potentially led by a CFO whose first task ought to be obtaining credible, consensus-based financial data. The Puerto Rico government’s release last week of a draft financial report – unaudited – for Fiscal Year 2014 only underscores this priority. All who are involved in charting Puerto Rico’s future course should insist that Governmental Accounting Standards be implemented as quickly as possible.*

* It is worth noting here that the federal government has long struggled to produce audited financial statements of its own. Moreover, the U.S. Department of Defense is currently in abject noncompliance with accounting procedures that could, if properly observed, save taxpayers tens of billions of dollars. NTU fully supports enactment of legislation, sponsored by a number of lawmakers from both parties, to rectify this deplorable condition.

The oversight entity should have the legal authority to demand available records, interview government managers, issue subpoenas, and facilitate negotiations that could allow the Commonwealth and its municipalities to enter into public-private investment partnerships.

Another witness before the panel, Thomas Moers Mayer, advised that a financial oversight entity for Puerto Rico should have approval authority over annual Commonwealth budgets as a condition for any federal aid, and that a Michigan-style emergency manager be given the latitude over public corporations to “hire, fire, reject and renegotiate contracts, revise work rules, and restructure pensions.”

NTU urges the Committee to employ this advice in delineating the powers of the oversight entity, which should be authoritative in the area of financial reform. In our opinion, the entity should not be provided with any type of debt restructuring authority (see below for elaboration).

Mr. Mayer’s testimony emphasized that the oversight entity’s members should be nominated by the President and confirmed by the Senate. This is a prudent direction to take, although another path presented itself in NTU’s discussions with the staff of Congressman Duffy over H.R. 4199, the Puerto Rico Financial Stability and Debt Restructuring Choice Act. As currently drafted, the President is authorized to empanel a Financial Stability Council after due consultation with Congressional leaders of both parties and the Resident Commissioner. Congressman Duffy’s staff told us that an alternative considering during the drafting of his legislation was a process whereby the House and Senate would jointly agree to a list of a specified number of candidates from which the President would be required to choose the oversight entity’s members.

Under no circumstances should an oversight entity’s composition or leadership be determined solely by the U.S. or Puerto Rican executive branches; nor should the selection of a Chair, CFO, or Manager be controlled by either government’s Treasury. Officials from Treasury Departments, including the Secretaries, should advise and assist, rather than serve on, the oversight entity.

On the same day that H.R. 4199 was introduced, Senator Hatch offered S. 2381, the Puerto Rico Assistance Act of 2015.  Both these bills contain significant (and similar) detail on how an oversight entity would function. In NTU’s opinion, each piece of legislation offers features worth the Committee’s deliberation … and each piece of legislation offers language the Committee should regard with caution. Some of those elements have been discussed above. Other considerations include:

  • Section 302 of S. 2381 outlines the scope of authority to include Puerto Rico’s public corporations. Whether or not the Committee’s final proposals are as strict as S. 2381 in terms of emergency manager and other powers (see Section 322), oversight of these quasi-governmental bodies is important and should be provided in some fashion. Care should be taken to avoid excessive interference with business operations that might deter future investment or prospects for privatization.

  • H.R. 1699 stipulates that every oversight entity member must have a primary residence in Puerto Rico. S. 2381 requires that a majority must maintain a primary residence in the Commonwealth, while a defined minority must not; all must be U.S. citizens. NTU understands the sensitive nature of Congressional legislation that specifies oversight authority on another government. We believe, however, that Mayor Williams’ observations on the need for expert advice – from a multitude of outside sources – should drive considerations of membership on the oversight entity. We therefore recommend greater latitude in allowing residents and nonresidents of the Commonwealth, to at least appear on a list of nominees for consideration.

  • While S. 2381 provides for certain auditing procedures in the interest of oversight, Section 201 of H.R. 1699 specifically instructs the oversight entity to contract for a full-scale independent audit of the Puerto Rico government’s financial practices. This is a wise starting point for any financial plan.

  • Although H.R. 1699 has well-written language (Section 203) regarding restricting the borrowing prerogatives of the Commonwealth government, S. 2381 (Section 335) clearly states that the full faith and credit of the United States is not extended to bonds issued by the oversight entity. NTU would caution against granting sweeping bonding powers to a new type of authority, but would urge a declaratory statement of this nature regarding the limits of federal liability for any current or additional Commonwealth or public corporation debt. Also, Section 333, which establishes a debt service reserve, might be usefully incorporated in other legislation to restore confidence in the Commonwealth’s ability to pay its debts.

2) Involve the U.S. Executive Branch Constructively. In the previous section NTU has cautioned against handing excessive power to the Executive Branches of either government in the operation of the oversight entity. Nonetheless, agencies in the U.S. government can and should have constructive roles in helping Puerto Rico stabilize its finances.

During his February 2 testimony to the Committee, Eric LeCompte made an eminently sensible plea for Congress to allow the U.S. Treasury’s Office of Technical Assistance (OTA) to offer its consultative expertise to Puerto Rico. OTA, whose mission is currently limited to foreign governments, only, could furnish important guidance to the Commonwealth on debt management that has helped other nations onto more sustainable paths.

In a similar vein, Section 601 of S. 2381 directs the Treasury, in concert with other agencies, to provide technical assistance to the Commonwealth in developing financial management, forecasting, information technology, and other fiscal procedures. While due diligence must be exercised over the government outlays involved in such exercises, NTU believes that the Committee should extend explicit federal assistance in these areas. While Washington is hardly a paragon of fiscal virtue, the exchange of information and techniques will ultimately benefit taxpayers.

NTU would also urge the Committee to consider creating a U.S. task force designed to expedite regulatory relief requests from the Commonwealth that are within the duly prescribed purview of federal agencies to grant. These could range from energy development permits, to property sales, to privatization efforts, to environmental easements. The task force should not merely identify obstacles to granting such requests, but actively facilitate them. Here again, the expenditure of federal resources on these activities should be prudently prescribed, but the dividends in helping Puerto Rico quickly achieve financial health could be considerable.

3) Make Whistleblower Protections a Priority. In NTU’s October 8th memorandum, I mentioned the need for any oversight entity, with Congress’s strong assent, to ensure that Commonwealth and other workers with knowledge of government waste, fraud, and abuse be provided with legal protections from retaliation or harassment from their employers.

The Commonwealth already has some experience with U.S. whistleblower statutes which, for example, applied to American Recovery and Reinvestment funds directed to Puerto Rico. A more comprehensive approach should include updating Puerto Rico’s own whistleblower protection laws to the highest possible standards.

Recently NTU asked staff with the Government Accountability Project (GAP), in our opinion the foremost authority on whistleblower protections in the U.S. and around the world, on advice for a “gold standard” that Puerto Rico could examine. GAP recommended that Puerto Rico’s current law should be compared to whistleblower statutes adopted by the government of the District of Columbia, but also referred us to a truly remarkable November 2015 document entitled “International Best Practices for Whistleblower Policies.” This treasure trove of information, authored by GAP’s Legal Director Tom Devine, demonstrates how whistleblower protections can be adapted and refined from a multitude of cultural perspectives.

NTU would urge the Committee to visit GAP’s website and incorporate its best practices to the maximum degree possible, not only in legislative provisions expressing Congress’s intent but also pertaining to the oversight entity’s mission.

II. Pro-Growth Economic Policies

At this point the Committee has received a litany of commentaries on options to aid Puerto Rico in its economic recovery. NTU’s October 8th legislative memorandum discusses many important steps to be taken in this regard, including privatization, taxpayer rights improvements, and minimum wage relief. In this communication, however, I wish to elaborate upon several matters and raise some additional ones.

1) Embrace Tax Reform that “Goes with the Flow.” Any successful economic growth plan for Puerto Rico must include both federal and Commonwealth-level measures to improve the tax system. A major challenge for Washington is crafting policies that are sufficiently vigorous as well as sufficiently resilient -- flowing along with, rather than standing against, the tide of tax reform efforts.

One approach would be to establish a dramatically simplified system such as a flat-rate income tax. While Washington, DC was under supervision of a control board, Delegate Eleanor Holmes Norton proposed legislation to exempt District incomes of below $15,000 from paying federal tax, while generally applying a 15 percent tax rate on amounts above that level. In explaining her motivation for introducing the bill, Delegate Norton said that “Nothing else matters if we continue to hemorrhage taxpayers.”

Puerto Rico is certainly hemorrhaging taxpayers, but there are practical considerations militating against such legislation. Most obviously, the majority of Puerto Rico residents are not liable for federal personal income taxes. Washington-based policy can have the most economic impact in addressing taxes levied on business (which affect all inhabitants of the island).

It is tempting for lawmakers to enact emergency-style measures such as investment tax credits, tax holidays, or enterprise zones, to provide Puerto Rico with a temporary boost. Yet this has complications of its own, including less stability (and therefore less economic growth) over the longer horizon. Equally important, however, is that this course would inevitably collide – on a political as well as an operational level – with efforts to reform the overall U.S. Tax Code.

In recent years policymakers have attempted to reach an understanding that would allow a major overhaul of the tax system to take place in a bipartisan manner. For 2016, House Ways and Means Committee Chairman Brady has proposed to focus his panel’s efforts on reshaping the Tax Code’s approach to toward U.S. companies’ foreign earnings. Puerto Rico is not a foreign country, but neither is it a U.S. state. For that reason, Congress had, since the early 20th Century, attempted to craft tax policy that balanced the close relationship between the island and mainland with the need to maintain outside investment. For better or worse, the last major exemption for Puerto Rican sourced income, through Section 936 of the Tax Code was phased out more than a decade ago.

Meanwhile, since that time the U.S. corporate tax system has become even less attractive overall. The flight of income and economic activity from Puerto Rico now has its parallel across the country, as firms have no choice but to protect their shareholders and invert headquarters elsewhere. Furthermore, NTU estimates that in 2015, the combined compliance burden in lost time and out-of-pocket costs for America’s income tax was nearly $234 billion. As our testimony before the Small Business Committee last year indicated, roughly two-thirds of this deadweight loss could be attributable to taxes on corporations, partnerships, and sole proprietorships. Entities with foreign operations faced some of the most disproportionate compliance expenses.

As Congress hopefully moves toward a less complex international tax regime that incorporates more features of territoriality and seeks to repatriate income from beyond our shores, it is sensible for federal tax policy in Puerto Rico to comport with – or at least not conflict with – these goals. Accordingly, NTU makes the following broad recommendations, based on briefings we have received from experts familiar with U.S.-Puerto Rico tax policy:

  • Reduce the U.S. tax rate on Puerto Rico-sourced income. Doing so could be made consistent with overall international tax reform, again recognizing Puerto Rico’s special status. Indeed, as Congress works to bring down the corporate tax rate for all businesses, the impact Puerto Rico experiences from such a change could guide policymakers in the next phase of reform.

  • Address base erosion concerns carefully. One criticism of the old Section 936 was that it contributed to the deterioration of the U.S.-Puerto Rico tax base. Through open letters to lawmakers and other commentaries, NTU has joined with many organizations cautioning against embracing Base Erosion and Profit Shifting (BEPS) strictures from the OECD. Rather, Congress should deliberate such measures independently and inclusively, so that BEPS rules for Puerto Rico are easily harmonized with whatever is developed under international tax reform.

  • This is especially the case with treatment of Subpart F income as it relates to broadly-defined investment in the island. Ultimately, under a tax system with more territorial features, Subpart F could be rendered superfluous. In the specific case of Puerto Rico, some kind of temporary deferred status for passive Subpart F income may be desirable to reduce disincentives for local investment. Nonetheless, such provisions should be made as simple and broad-based as possible.

  • Set a Puerto Rico repatriation or dividend deduction at a similar level to what policymakers have discussed recently for an international tax reform package. Among the models for reaching this objective would be the American Jobs Creation Act of 2004 and the Economic Revitalization Tax Act of 2001, as well as the Tax Reform Act of 2014. Both of these proposals set the dividend exemption at 85 percent.

Hand-in-hand with U.S. government action must come additional reform efforts in Puerto Rico’s own tax laws, as NTU’s October 8th memorandum recounted. Indeed, a structure that encourages more business activity on the island could help to raise business property values and provide an opportunity for reexamining the entire assessment process for real estate and personal property taxes. As several analysts have noted, Puerto Rico has not conducted a general reappraisal of property taxes since 1958. This is not a unique aspect of the island’s system. Several U.S. states, among them New Jersey, New York, and Pennsylvania, have no set reassessment cycle for their localities.

Some would argue that the purpose of regular reassessment should be simply to fill government coffers with more revenues. NTU disagrees with this contention. In fact all three of the states mentioned above are already characterized by heavier than average property tax burdens. Rather, the point of periodic reappraisal is to ensure accuracy, transparency, and public confidence in the entire property tax system; over the long term, these factors lead to better voluntary compliance and more stable collections that are still sufficiently responsive to market conditions.

The Council on State Taxation and the International Property Tax Institute have published a highly relevant worldwide scorecard entitled “The Best and Worst of International Property Tax Administration,” in which Puerto Rico received an overall grade of “D” for its practices. The composite rating considered many factors in property tax administration. Puerto Rico received “A” grades in the consistency of its forms and compliance deadlines, but was awarded “F” grades for items such as unequal assessment ratios and a disproportionate burden of proof on taxpayers.

NTU believes that lawmakers should express the sense of Congress in any rescue package for Puerto Rico that island officials and the oversight entity work on holistic reform to the municipal property tax system, including but not limited to the reappraisal cycle.

2) Ramp-Up Private Sector Energy Solutions. This Committee’s January 12th hearing provided the clearest illustration yet of Puerto Rico’s energy development woes and the outmoded entity supporting it, PREPA. Many of the witnesses testified about the need to strengthen accountability, guard against improper payment, increase efficiency, and update the infrastructure.

As Members of the Committee may know, NTU has strongly supported measures to allow oil and natural exports as well as streamline terminal and pipeline permitting processes. Although Puerto Rico’s location and its renewable potential present unique considerations, clearly the island could gain in the near term by easing federal restrictions on liquefied natural gas terminal construction and obstacles for cost-effective U.S. LNG shipments (see our Jones Act comments below). An LNG facility on the north side of the island would not only broaden Puerto Rico’s energy supply options, it could also help promote energy trade from more sources.

Policymakers should also evaluate whether federal and Commonwealth rules may be working at cross-purposes and impeding expansion as well as diversification of the power grid. For example, net metering, which allows customers with distributed generation technologies to sell power back to the grid, can act to raise prices for low-income consumers without such service – an especially sensitive issue for Puerto Rico, where energy costs are already quite difficult to bear. Meanwhile, several U.S. states, among them Massachusetts and New York, continue to provide counterproductive solar energy financing programs that are unfairly competing with private-sector alternatives that offer good terms to customers without burdening taxpayers. Puerto Rico’s solar programs should be examined to root out similar flaws.

Moreover, in a late 2013 media interview, solar financier Robert Sternthal cited unrealistic Minimum Technical Requirement procedures and an arbitrary contract negotiation process as two major hurdles to investing in Puerto Rico. The Committee should examine whether PREPA or federal agencies have a role in improving these conditions by cutting red tape.

Regarding efficiency issues, one tool NTU recommended in its 2015 memo is Energy Saving Performance Contracts (ESPCs) whereby private firms competitively bid to upgrade government facilities using their own up-front financing and employing their own labor. Contractors then recoup their investment from resulting cost savings (which are verified using contractually negotiated criteria), with taxpayers first in line to receive the dividends before any appropriations against cost reductions are made. If savings fail to materialize in any given ESPC, the contractor is responsible for making the government whole.

As you know, the U.S. government has been embracing ESPCs, but there are still many facilities that could benefit from this procedure. The Committee could adopt legislative language requesting the Federal Energy Management Program (FEMP) to conduct a quick survey of federal properties in the Commonwealth of Puerto that may still be suitable for ESPCs, and direct the agencies managing those facilities to make ESPCs a priority. Private companies could upgrade certain buildings with surprising speed.

The Commonwealth has already developed procedures for its entities to adopt ESPCs. Much like FEMP, the Puerto Rico Energy Affairs Administration (PREAA) provides guidance. The stabilization authority could be directed to PREAA’s results compared to FEMP’s and recommend any remedial actions.

3) Reduce Infrastructure Costs.  NTU’s October 8th, 2015 memorandum discussed the need for open competition in materials selection for infrastructure projects. Citing testimony we provided one of your colleague Committees in 2014, NTU observed:

Although far from perfect, recent Congressional action on a pilot program version of the Water Infrastructure Finance and Innovation Act is a sign of bipartisan interest in developing alternatives to high-cost funding processes for water and sewer initiatives. Other commendable strides have been made in the clean-water grant programs of the U.S. Department of Agriculture’s Rural Development Office and Rural Utilities Service, both of which build safeguards into their disbursement procedures that hold project leaders accountable for practicing open procurement policies.

Furthermore, though it was flawed in numerous aspects, the Moving Ahead for Progress in the 21st Century Act made a more robust federal (and state) commitment to Life Cycle Cost Analysis (LCCA) techniques for transportation projects. LCCA has an integral role in ensuring that open competition procedures yield the most effective result for taxpayers.

How could such principles work in practice? This Committee could recommend that all federal infrastructure grants, not just those pertaining to USDA and RUS, contain open procurement best practices. At a minimum, any aid of a temporary or emergency nature to Puerto Rico involving infrastructure could incorporate such taxpayer protections. Simple but effective model legislative language has been developed by the American City-County Exchange for both state and municipal governments that can be adapted for Congressional action and employed by Puerto Rico’s Legislature to incentivize the Commonwealth’s own PRASA:

Section 1. {Definitions}
(A) “Governmental Agency” refers to any county government or municipality.
(B) “Acceptable Piping Material” refers to piping material that meets current and recognized standards as issued by the American Society for Testing and Materials (ASTM) and the American Water Works Association (AWWA).
Section 2. {Procurement Procedures for Water and Wastewater Piping}
(A) Government agencies shall engage in open competitive bidding to study, plan, design, construct, develop, finance, maintain, rebuild, improve, repair, or operate water and wastewater utilities; and
(B) All procurement transactions for piping material shall be conducted in a manner that provides for open and free competition. All acceptable piping materials shall be considered in the procurement process.
(C) Government agencies shall consider the quality, sustainability, durability, structural integrity, soil compatibility, permeability, ease of repair, abrasion resistance, and constructability and corrosion resistance when procuring piping material.
(D) Government agency employees shall not participate in the selection process when those employees have a relationship with private entities seeking a contract under this Act or as proscribed by existing state or local contracting law.
(E) All procurement transactions, regardless of whether by sealed bids or by negotiation and without regard to dollar value, shall be conducted in a manner that provides maximum open and free competition. Procurement procedures shall not restrict or eliminate competition.
(F) Unlawful restrictions on competition include, but are not limited to:
(1) Placing unreasonable requirements on firms in order for them to qualify to do business;
(2) Noncompetitive practices between firms;
(3) Organizational conflicts of interest;
(4) And unnecessary experience and bonding requirements.
(G) In addition the Government Agency shall consider all materials normally suitable for the project commensurate with sound engineering practices and project requirements.

Although this particular model legislation applies to water and sewer projects, it can be suitably modified for other types of infrastructure.

4) Proceed with Incremental Jones Act Reform. Predictably, longstanding political tensions have resurfaced as debate over the government of Puerto Rico’s request for repeal of Jones Act shipping restrictions. NTU has favored across-the-board repeal of the Jones Act for decades, but opposition from small but powerful maritime interests remains.

The people of Puerto Rico and other jurisdictions are suffering from higher shipping costs from the U.S. mainland (and consequently higher prices for goods). This is especially true for energy – according to Patrick Holland, a contributor for Economics21, U.S. LNG bound for Puerto Rico bears a 30 percent markup due to Jones Act policies. A University of Puerto Rico analysis indicated that in 2010 alone, Jones Act strictures cost Puerto Rico residents more than half a billion dollars.

This human misery is entirely within Congress’s power to alleviate, and the proposal by the Hawaii Shippers Council mentioned in NTU’s October 8th memo is a sensible starting point. The Noncontiguous Trades Jones Act Reform (NTJAR) plan would provide relief from federal “U.S. build” dictates that drive up the cost of shipping between the U.S. mainland and Hawaii, Guam, Puerto Rico, and the Virgin Islands. The proposal, which would not change U.S. flag, ownership, or crewing provisions in any other portion of commerce, is targeted to address some of the worst aspects of the Jones Act. According to the Council, NTJAR would “allow U.S. shipowners to purchase large self-propelled merchant ships meeting U.S. Coast Guard standards from qualified shipbuilders in other industrial countries and renew their aging noncontiguous fleets (average age 28 years while the international norm is 12 years) with much lower cost, more efficient modern ships.” The advantages would be numerous, as the Council explains:

  • “Significantly reduce barriers to entry and increase competition in the Jones Act noncontiguous domestic trades.

  • Reduce freight rates – through lower capital costs and greater competition – to Hawaii, Alaska, Guam and Puerto Rico and lower the cost of living in those jurisdictions.

  • Stop consumers in the affected noncontiguous jurisdictions from being forced to pay substantially higher freight rates to subsidize an inefficient, extremely expensive and commercially uncompetitive U.S. major shipbuilding industry that has constructed on average fewer than three large merchant ships per year since the mid-1980s.”

As supporters of NTJAR point out, some 6 million consumers in noncontiguous areas are negatively impacted by these rules. Congress has so far resisted making even modest changes to the law. If conditions in Puerto are as dire as so many believe, we know of no more urgent or opportune time to take this carefully measured step.

III. Debt Restructuring

A trite opening to this final portion of our comments might be “last but not least.” Yet, the discussion over debt restructuring mechanisms for Puerto Rico should not be the first order of business for Congress. Without proper development of oversight structures and policies to encourage economic growth in Puerto Rico, the energy spent upon establishing municipal bankruptcy procedures for the island will be pointless.

Some argue that Congress’s decision to withdraw any Chapter 9 authority from Puerto Rico in 1984 was an act of aberration rather than intent. Others believe, however, that the 1984 legislative language was consciously defined to separate Puerto Rico from the states in terms of bankruptcy policy.

In NTU’s opinion this and other controversies do not adequately confront the fundamental question of whether current sovereign debt restructuring procedures are successful anywhere in the United States. Given the immediate urgency of Puerto Rico’s situation a systematic reexamination of Chapter 9 may not be feasible at this time. Nonetheless, as with pro-growth tax reform, the answers to this question can inform policymaking for Puerto Rico now and for the entire United States soon afterward.

Defining the “success” of Chapter 9 can take on many meanings. For debtors, it could mean “breathing room” to rationally structure interest and principal payments under a unifying authority. For creditors, it could mean a measure of justice in satisfying at least part of legitimate claims that might not otherwise be paid. For participants in the local economy, it could mean freer-flowing capital markets. NTU contends that from the broad perspective of taxpayers, the “success” of any municipal debt reorganization process must also be evaluated by its capacity to mitigate fiscally irresponsible borrowing practices of the past and diminish their potential to resurface in the future. None of these views are mutually exclusive.

NTU is offering the following observations in the interest of sound policy that will benefit taxpayers in Puerto Rico and the rest of the United States.

1) Avoid “Super” Restructuring Regime and Codify Any Restructuring Authority. NTU believes that creating new powers to retroactively void debt agreements without creditor consent, or subject new categories of debt (i.e., “full faith and credit” bonds) to restructuring would be the highest violation of the rule of law. Vesting such power in a financial oversight entity, or the Executive Branch of either the U.S. or Puerto Rico, or through some kind of “special master,” would only compound the injury. In the near term, Puerto Rico’s residents would endure the most pain, as the island becomes radioactive to future investment because its government will have demonstrated it places no value in “full faith and credit” guarantees. Over the longer term, taxpayers would face similar demands for “Super” restructuring from chronically irresponsible U.S. states.

Whatever restructuring authority Congress chooses to grant must be limited, clarified, and codified, leaving no room for mischief that could harm taxpayers.

2) Debt Restructuring Must Adequately Support Long-Term Fiscal Correction or Healthy Investment.

Many fiscal conservatives have been led to conclude that bankruptcy is the best way for municipalities to shed themselves of massive costs that would otherwise be politically untenable to address, among them government employee pension and health care burdens. For their part, the unions representing these workers contend that their members alone bear the brunt of such bankruptcies.

The recent experience of municipalities through Chapter 9, among them Detroit and Stockton, shows that bondholders tend to take “haircuts” on their investments that are increasingly larger than what governments and their employees are asked to sacrifice. Aside from a potential chilling effect on the municipality’s future investment climate, this imbalance also reduces the incentive to reverse poor decision-making that could ultimately burden taxpayers further and precipitate future debt crises. Meanwhile, residents within the cities are sometimes left facing steep tax hikes, while taxpayers across a given state are often made liable for loans or other emergency financing.

As Ty Schoback and Michael Taylor of Columbia Threadneedle Investments wrote in 2014:

The market seems to have underestimated the political influence pensioners wield in bankruptcy. The Detroit and Stockton bankruptcies resulted in much more favorable treatment for pensioners at the expense of bondholders. In the case of Detroit, bondholders received haircuts to their claims ranging from 26%–87%, while pensioners received a haircut of only 18%. The idea that pension obligations hold a senior position to the full faith and credit general obligation (GO) pledge represents a harsh new reality.

Unlike in corporate bankruptcies, only the insolvent municipality is permitted to submit a plan of adjustment. This means that, from a practical standpoint, the city is in control of the Chapter 9 process and is the only entity able to propose how it would like to treat various creditors. The only limitation is that a judge must deem treatment of all creditors to be “fair and equitable” and the overall proposed plan of adjustment “reasonable.” Unfortunately, Detroit and Stockton taught us that “fair and equitable” does not translate as “equal” recovery values.

Simply hoping that Chapter 9 would not turn out this way in Puerto Rico is not realistic. Other safeguards, built into the laws themselves, must be considered.

3) State Attempts to Fine-Tune Chapter 9 Have Had “Teachable” Results. If an orderly municipal debt restructuring mechanism fails to establish the conditions we note above, a de facto taxpayer bailout consisting of government-backed loans, subsidies, and other support would likely occur. For this reason, policymakers in Puerto Rico and Washington, DC should consider restructuring options that reflect the best (and worst) experiences of the states. NTU believes the following are among the most instructive:

  • Pennsylvania’s Act 47 creates a system of state financial supervision that is intended to avoid municipal bankruptcy. The majority of local governments participating in this system have remained under a declaration of financial distress for years, even decades. But is this an indication of a breakdown in the alternative structure or an admission that localities have simply failed to appreciate the need for a dramatic change of course? Both appear to be true. In effectively forbidding the Act 47 city of Scranton from rightsizing city employee benefits and freezing compensation, the State Supreme Court created a precedent that removed a vital budget recovery option for many ailing Pennsylvania governments. On the other hand, the state offers emergency aid to Act 47 cities that may create a moral hazard to continue mismanagement or tolerate corruption.

    The cities that have exited Act 47 have often severely raised taxes on their residents, but have also recognized the need for better and more transparent tax administration. Although the city of Nanticoke sharply increased tax burdens, officials there also took the step of conducting a city-wide property reassessment, something which had not been completed for more than 40 years. Nanticoke officials gave further credit to the Pennsylvania Economy League, a nonprofit civic-level think tank, for helping to draft elements of the city’s rescue plan that ultimately got some expenditures under control.

  • In Michigan, half a dozen cities have come under “emergency managers” whose powers have been tested in the courts, while New Jersey has in the past taken over most of Camden’s city services. Yet, like Pennsylvania, Michigan and New Jersey have provided extensive state-level aid to local governments teetering on the edge of bankruptcy. While most of Michigan’s and all of New Jersey’s cities have avoided bankruptcy, doing so has required massive infusions of taxpayer cash.

  • Several years after Orange County’s bankruptcy, California’s AB 506 created a requirement that a municipality engage with creditors in an alternative dispute resolution (ADR) process overseen by a state-approved “neutral evaluator.” Widely seen as a way for government employee unions to defend untenable compensation packages from restructuring (as in the City of Vallejo), AB 506 has to most legal observers complicated and drawn out debt restructuring with few benefits.

  • An 85-year-old law in North Carolina has maintained a strict state-level supervisory and approval process for the sale of local debt. Although this oversight can be quite strict, even consisting of edicts to local leaders on budgeting decisions, the result has been above-average credit ratings and comparatively healthy government pension systems. The law has also helped the state itself to avoid the politically expedient but costly path of simply extending its own credit to distressed municipalities.

  • Central Falls, Rhode Island’s bankruptcy helped to catalyze a statewide effort to restructure government pension plans that was widely acknowledged to be path-breaking, because it enacted prudent cost-control measures affecting both current and future retirees. But an analysis by the Pew Charitable Trusts noted that Central Falls “avoided the kind of prolonged bankruptcy of cities such as Vallejo, CA … largely because of another way the state intervened.” Rhode Island’s Legislature passed a law in 2011 not only guaranteeing that bondholders would be made whole even in the event of a municipal bankruptcy, but also providing bondholders with the ability to file liens against city tax revenues. Pew cited Judge Frank Bailey, who said after approving the restructuring of Central Falls’ debt restructuring, “this is an example – for not only Rhode Island but maybe the nation – on how to run a Chapter 9.” 

    Central Falls taxpayers were not left unscathed in this process; they were forced to endure a large property tax hike, even amidst much-needed reforms to city worker compensation.

4) The U.S. and Puerto Rico Governments Must Design Sensible, Limited Restructuring Capacity that Does Not Impede Reform. Rosemary Gallogly, Rhode Island’s Revenue Director during the Central Falls crisis, most accurately captured many taxpayers’ sentiments when she remarked, “I don’t view bankruptcy as a tool in the toolbox. It’s a last resort and should be utilized if there are no other options for a community.”

While virtually all policymakers would agree that municipal bankruptcy is a “last resort,” too many leaders still tend to view this process as some mechanical implement that will “fix” a local government’s problems. NTU believes the opposite is true: debt restructuring, preferably through voluntary negotiations, is merely the finishing touch that can only be applied after the fundamental “fix” has been made through oversight and fiscal policy reforms. Bankruptcy, in particular, is best viewed as a “never resort.” As Thomas Moers Mayer noted before the Committee on February 2, the 1995 report accompanying legislation establishing the District of Columbia Control Board found that “the Bankruptcy Code as it stands is neither intended to nor designed to promote judicial restructuring of a municipal government that suffers from chronic, structural budget deficits.”

Unquestionably many of Puerto Rico’s entities suffer from such deficits. The comparison to the District of Columbia is also appropriate on several other levels. Like the District, Puerto Rico is not a state, though it historically has close ties to the federal government. Like the District, Puerto Rico has a strong movement for U.S. statehood. Like the District, Puerto Rico’s financial challenges transcend current bankruptcy law and require thoughtfully tailored responses that avoid moral hazard.

Some Republican and Democratic lawmakers insist that there are differences in Puerto Rico’s situation that require consideration of some kind of restructuring option. They contend that the volume of debt, the lack of transparency, and the protracted nature of recent negotiations all call for a legalistic response.

If this is the direction the Committee intends to take, NTU would remind lawmakers of the phrase in that 1995 report, “the bankruptcy Code as it stands.” On one hand, they must avoid the temptation to create “Super” restructuring regime, which would upend rule of law and establish a toxic environment for any remaining prospects of future economic vitality. This scheme would worsen virtually of the negative outcomes under current Chapter 9 law, increasing by an order of magnitude the impulse to shun long-run fiscal discipline.

On the other hand, they should consider restructuring policies that have the greatest promise of success for taxpayers. Members of this Committee, along with their colleagues on other committees, have the heavy task of determining whether such policies can be formulated. In so doing, we offer the following principles.

  • Re-Examine Previous Parts of the Law. Thomas Moers Mayer raised the interesting historical point that creditors once had a meaningful ability, through majority vote, to consent to a bankruptcy case, “but the 1978 statute reduced the vote to a formality.” Furthermore, creditors are not permitted to propose their own restructuring plan once Chapter 9 proceedings have been initiated.

    Congress could consider surgically amending current Chapter 9 statutes to create these creditor safeguards, paying special attention to ensuring that they work to reinforce the principle that budgetary restraint, not bankruptcy, is the best outcome for a troubled municipality. Preferably such changes should be considered applicable for all localities, not just prospectively for those in Puerto Rico.

  • Carefully Examine Other Parts of Bankruptcy Law. Although California’s AB 506 has proven problematic, it has raised an important issue of how other bankruptcy law strictures might be able to rebalance the process. For example, Chapter 11 of the U.S. Code provides latitude for a bankruptcy court to remove the shackles of collective bargaining agreements under certain circumstances (i.e., the debtor has presented a thorough, transparent proposal, the creditor has not shown “good cause” for rejecting renegotiation, and the “balance of equities” would favor renegotiation).

Incorporating similar provisions in Chapter 9 at the federal level, for Puerto Rico and for all U.S. states, would be difficult. In a 2014 article for the Cardozo Journal of Conflict Resolution, Michael Galen raised some practical difficulties of doing so in California, writing that “aside from the potential constitutional issues … that can arise due to such a putative total incorporation of [Section] 1113 into Chapter 9, a wholesale incorporation is unnecessary.” He then suggests that AB 506 could instead be improved “by means of incorporation of certain [Section] 1113 strategies.” This could take the form of providing tests in the arbitration process that would, if the process failed and a Chapter 9 petition was made, assist the court in determining whether bankruptcy was justified.

Chapter 9 bankruptcies certainly involve more parties than pension funds or collective bargaining agreements for government worker compensation. Yet, clarifying the role of these participants and preventing their undue influence over the process is vital. Pension fund claims are, after all, especially onerous. Other bonds have ascertainable terms, but pension liabilities are perpetual and volatile.

  • Build Effective Alternatives to Bankruptcy. Though local leaders accustomed to a degree of autonomy might resent a North Carolina-style debt supervision commission looking over their shoulders, creating such a commission would help to address concerns that Commonwealth-level officials in Puerto Rico have voiced over the often chaotic practices of municipalities. Even a less restrictive law that only followed North Carolina’s practice of close state-level evaluation of localities’ financial reports would be a boon to the island’s future path to stability.

In addition, some U.S. state laws actively encourage troubled municipalities to seek consolidation with other governments. Though not cure-alls for underlying mismanagement, consolidations can ease the potential for worse impositions on taxpayers by offering economies of scale and fresh approaches to longstanding problems.

Finally, Rhode Island’s experience of putting the primary focus on reforms to budgetary cost drivers and prioritization for certain creditors helped to arrest a trend of bankruptcies and at least stabilize the municipal investment climate. All of these protections could be expressed as Congressional intent in any legislation dealing with restructuring.

  • Recognize the Contributions of the Private Sector. Whatever successes that have occurred under Pennsylvania’s Act 47 owe much to the managerial expertise with nonprofit organizations that have aided in the development of municipal recovery plans. As mentioned in a previous section, other entities could offer a vast pool of talent to advise Puerto Rico’s leaders on activities ranging from whistleblower protections to local contracting reforms. A financial oversight board for the Commonwealth could be charged with engendering consultative relationships outside the public sector, which will strengthen Puerto Rico’s fiscal institutions long after the board has dissolved.

Furthermore, the Committee should give due consideration toward facilitating clarity in future bond issues. Amid worldwide discussions over sovereign debt restructuring mechanisms, the George W. Bush Administration proposed greater voluntary reliance on collective action clauses (CACs) in sovereign bonds. CACs sharpen the ground rules for resolution between debtors and creditors in advance, so as to bolster investor as well as issuer confidence. Some industry leaders, Ed Bartholomew and Ernie Stern of J.P. Morgan among them, have at times suggested that bonds could be swapped out for instruments with CAC clauses, thereby aiding shorter-term restructuring.

In an April 2015 article for Revista Juridica UPR, Antonio Pietrantoni raised the intriguing question of how and whether CACs could be employed in the service of addressing Puerto Rico’s municipal debts. The Committee should quickly explore the issues and sources cited in this piece, including the experience of Belize. It is possible that federal guidance, or even incentives, could help to promote the development of this tool.

As Congressman Duffy has explained upon the introduction of his own legislation, many refinements must still be made to produce a legislative solution for Puerto Rico’s finances that is sufficiently vigorous but properly restrained. In no other area is this more important than debt restructuring facilities. The goal seems paradoxical but it is also imperative: to design a restructuring regime that encourages stakeholders to avoid it and instead negotiate an equitable settlement.

Conclusion

NTU has produced several lengthy taxpayer-oriented analyses and commentaries in the hope of providing public officials and citizens with actionable advice to help Puerto Rico attain the economic vitality and financial viability it deserves. It is offered with the humility that Washington, DC, is neither blameless nor authoritative in crafting a way out of Puerto Rico’s fiscal entanglements. It is also offered with an eye toward the future – a future that provides valuable lessons for U.S. states as well as the federal government. A great deal is at stake in formulating proper policy in what has become a situation whose financial ripple effect is extending far beyond the island shores of Puerto Rico. Working together, policymakers at all levels can serve taxpayers in the Commonwealth and across the United States. NTU would be honored to offer whatever assistance it can in this endeavor.