Bankruptcy process: US Court to hear arguments on Employees Retirement System bond issuances

By The Star Staff

The U.S. District Court is slated to hear arguments next Thursday on an important aspect of Puerto Rico’s bankruptcy, which is whether the Employees Retirement System (ERS) was legally authorized to issue $3 billion in bonds in 2008.

If the court determines ERS was not authorized, it would wipe out the entire debt and the bonds would be worthless.

The ERS is one of five entities currently in bankruptcy under the federal Puerto Rico Oversight, Management and Economic Stability Act, commonly known as PROMESA. The Financial Oversight and Management Board wants to annul the payments, and for some time has been battling creditors on the issue.

The dispute is over whether the ERS was authorized under its charter law to issue $3 billion in bonds in 2008. The law allows the ERS to conduct borrowings, and creditors have contended that the bond issue was a loan.

According to the bondholders, the ERS borrowed nearly $3 billion in 2008, via a sale of three series of ERS bonds to a syndicate of underwriters. The transaction was authorized by the ERS’s board of trustees and by the now-defunct Government Development Bank.

The validity of the resulting debt was confirmed repeatedly by legal opinions from Puerto Rico’s secretary of Justice, from the ERS’s general counsel, and from the island law firm of Fiddler, González & Rodríguez. All three nationally recognized bond-rating firms rated the bonds investment grade and there was no mention that the bonds could be invalid, the bondholders said.

Initially, between 2004 and 2006, the commonwealth itself would have issued $2 billion in bonds payable from a general fund and transferred the net proceeds to the ERS, but the island Legislature did not act on the legislation to execute the bond issue. As a result, the ERS in 2006 and 2007 evaluated an alternative proposal under which the ERS itself, rather than the commonwealth, would issue bonds.

In March 2007, the ERS received a legal opinion from Fiddler, González & Rodríguez that concluded that “the system is authorized pursuant to Section 4-105(d) of Act 447 [codified at 3 L.P.R.A. § 779(d)] to incur debt secured by the assets of the system, and the bonds are such a debt,” and that legislative approval was not needed.

The federal oversight board and the Unsecured Creditors Committee have argued that while the ERS was allowed to seek a loan, it was not permitted under the language of its own statute to issue bonds. They noted that the $3 billion was in bond issuances marketed and sold by underwriting syndicates, led by UBS Financial Services Inc. The ERS did not engage in any direct negotiations with the public investors in setting the terms or establishing bond prices. Instead, the ERS provided necessary documentation — its official statements, bond resolutions and other bond documentation — to UBS and the other underwriters to use in their direct discussions and negotiations with public investors. The ERS bond issuances contemplated that UBS and the underwriting syndicates would fulfill an intermediary function by buying ERS bonds for resale to public investors.

The Bank of New York Mellon, as fiscal agent, said the ERS statute authorized the bonds as a borrowing from financial institutions and as a direct placement of debt. The bank said that under the Uniform Commercial Code, which is enforceable in Puerto Rico, the bonds are valid regardless of any defect.

“Even though a security may be issued by a governmental issuer with a defect going to its validity, the security nevertheless is valid in the hands of a purchaser for value and without notice of the particular defect,” the bank has said.

In 2011, the island Legislature amended the ERS Enabling Act to ensure that the ERS would not conduct another public bond issuance. In the statement of purpose for the 2011 amendment, the Legislature wrote that the issuance of the ERS bonds was illegal.

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