Puerto Rico’s Audacious Move: Can it Cut its Debt by $6 bn?

Mitu Gulati & Mark Weidemaier

Last week, the Government of Puerto Rico, acting through the Financial Oversight and Management Board (and in conjunction with the creditors’ committee), filed a claims objection seeking to invalidate roughly $6 billion of its General Obligation debt. The reason is that the government allegedly borrowed in violation of the Debt Service Limit and the Balanced Budget Clause of the Puerto Rican constitution. Stephen’s recent post on this subject discusses the merits of this argument in some detail. In this post, we are especially interested in the question of restitution. The Commonwealth doesn’t get much benefit from invalidating loans unless it also avoids the obligation to pay restitution (i.e., return the purchase price). So the objectors make the additional argument that bondholders have no equitable right to restitution under a theory of unjust enrichment.

There is some precedent for the objectors’ arguments in similar contexts, although not a lot of it. Some of the important cases, such as Litchfield v. Ballou (1885), are also very old. However, at least one law review article—a student note in the North Carolina Banking Institute journal (here)—squarely addresses Puerto Rico’s argument, ultimately concluding:

How can Puerto Rico’s penalty for illegally borrowing above its means be that it is allowed to declare the debts void and keep the money for itself? Despite the manifest unfairness of such a result, the applicable law indicates that this is likely the proper legal result.

It might seem unfair for bondholders to get nothing. But as a matter of basic contract law, there is a plausible argument against restitution. Here’s section 197 of the Restatement (Second) of Contracts: “[A] party has no claim in restitution for performance that he has rendered under or in return for a promise that is unenforceable on grounds of public policy unless denial of restitution would cause disproportionate forfeiture.” (The fact that bondholders will lose their expected payments does not make forfeiture “disproportionate.”) And here’s the most relevant exception, in section 198: “A party has a claim in restitution … if (a) he was excusably ignorant of the facts or of legislation of a minor character in the absence of which the promise would be enforceable, or (b) he was not equally in the wrong with the promisor.” Readers interested in this topic, which we think quite fascinating, should check out Juliet Kostritsky’s Illegal Contracts and Efficient Deterrence. To be clear, the Control Board bases its argument on the Commonwealth’s law—for example, on the proposition that the Constitution invalidates other provisions of law (including the UCC) that might provide bondholders a remedy. We reference elementary principles of contract law only to show that readers should not view the objectors’ arguments as demanding radical changes to well-established law. It’s quite clear that the law permits (if not requires) exactly the result the objectors seek to achieve.

Thus, while the objection has no doubt made some market participants apoplectic, it is not especially radical as a legal matter. Nor is it novel factually. Other governments have raised, or might plausibly raise, similar arguments. In its bond litigation against Russia, Ukraine argued (and lost) that the $3 billion Russian bond issue violated Ukrainian law. Likewise, at least some portion of Venezuela’s outstanding debt—especially loans incurred by the Maduro government—might plausibly be challenged by a successor government as illegal under Venezuelan law (see here and here).

One argument for allowing governments to avoid loans without paying restitution is that investors in these types of instruments are sufficiently informed to evaluate a loan’s legality. Put differently, and in terms that echo the Restatement (Second) of Contracts: investors are neither “excusably ignorant” of the debt limit violation nor less culpable than the government. Of course, the lawyers for the underwriters will issue an opinion letter affirming the legality of the deal, but investors are capable of conducting their own evaluation. Or perhaps investors should focus their ire on bond counsel instead (as the previously-linked note in the NC Banking Institution discusses at pp. 214-15).

To be sure, sovereign debt practice (and maybe law) generally does not let a government avoid debts incurred by a predecessor, even when the debt is odious or illegitimate. A case that comes to mind is Republic of Iraq v. ABB et al., 768 F.3d 145 (2d Cir. 2014). Oversimplifying, the post-Saddam government of Iraq was trying to disclaim responsibility for the previous government’s involvement in corrupt transactions. The Second Circuit, however, refused to draw a distinction: “where a plaintiff in Iraq’s position bears fault, it does not escape the consequence of its wrongdoing on the basis of a change in leadership.” The objectors’ argument, however, is not predicated on a distinction between the government that incurred the debt and the government that now wants to avoid it. It argues that the loan was, and remains, illegal. That argument also heads off any claim that the Puerto Rican government subsequently ratified the loan by continuing to make coupon payments. An illegal contract can’t be ratified unless the circumstances making it illegal have been removed.

If the Control Board wins, it is an interesting question how the market will react. Needless to say, there has been much discussion in the financial press (see here, here, here and here). Unsurprisingly, some market participants are outraged and predict that the sky will fall and that Puerto Rico’s borrowing costs will increase dramatically.

Maybe; maybe not. Let’s assume part of Puerto Rico’s debt was illegally issued. Will the market penalize Puerto Rico for retroactively policing this illegality? This strikes us as an empirical question without an obvious answer. The economic logic behind constitutional debt limits and balanced budget rules is that such commitments help ensure fiscal prudence, which should reassure investors and protect the borrower’s citizens and residents from the costs of excessive debt. But these benefits require that the commitment to fiscal prudence be credible, and that requires institutions capable of enforcing discipline. (There is of course an important literature on this subject, including foundational work like Douglas North and Barry Weingast’s Constitutions and Commitments.) Allowing the government to avoid illegal loans ex post might create positive incentives. Perhaps the bankers who engineer these deals, and the lawyers who write comfort letters, will police transactions more carefully in the future. If so, investors may view the Commonwealth’s commitment to fiscal prudence as more credible, and borrowing costs might go down. Ultimately it’s an empirical question. For example, one might ask whether yields on Puerto Rico’s other, legally issued, debt are increasing thanks to this case (correcting, of course, for the effect of the reduction to the debt stock).

Bottom line: This is going to be a fascinating case with big implications in the future.