The Demise of Puerto Rico Is in Part Attributed to U.S. Congressional Action

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Milton Vescovacci

By Milton Vescovacci, Esq.

Milton Vescovacci is a GrayRobinson shareholder in the Corporate and International Practice Groups. He represents domestic companies in a variety of corporate, tax, distribution, marketing, import, intellectual property, employment, immigration, real estate, M&A and investment matters. He advises international clients who want to do business in the U.S. Milton is fluent in Spanish and Italian. Milton was born in Puerto Rico. He grew up in New York City, attended high school and first year of college in Puerto Rico, and later trained in New York City on Wall Street as an investment banker for Bank of America and Chase and as an attorney at the law firm Sidley Austin in New York City and at Akerman Senterfitt in Miami before leading the Corporate Practice at GrayRobinson in Miami. Milton has spoken on the topic of the Puerto Rican debt crisis in various Puerto Rican chamber events and is advocating through such chambers for relief for Puerto Rico.

On July 1, 2016, a $2 billion ticking time bomb will explode, figuratively speaking, if the U.S. Congress fails to take action to help the beleaguered Puerto Rican economy currently embroiled in a debt crisis. The Government of Puerto Rico has openly admitted to its inability to pay this next debt payment when it becomes due on July 1. The debt crisis and the depressed economic conditions on the island territory of the U.S. are, in part, directly attributed to U.S. Congressional action that dates back to the early 1900s when the U.S. took over control of Puerto Rico from Spain, following the Spanish-American War of 1898. The Puerto Rican government is not free from blame or responsibility in getting to this extraordinary debt crisis through its dependence on debt to fund its subsistence. This article will consider the many actions taken by the U.S. Congress and the status of Puerto Rico as a territory of the U.S. that led to the current debt crisis and to the island's dependence on debt.

Since the Treaty of Paris of 1898, when Spain gave control of Puerto Rico to the U.S., the U.S. Congress has had sovereignty over the island territory. A series of Congressional actions helped prop up and promote the Puerto Rican economy. In 1900, the U.S. Congress passed the Foraker Act, which made all federal laws of the U.S. apply to the island and created a political structure - including a governor, a House of Representatives with 35 locally elected members, a non-voting Resident Commissioner in the U.S. Congress, a judicial system with a Supreme Court, a U.S. overseen National Guard and defense, application of U.S. maritime and international trade laws, and federal income tax exemption. In 1917, the U.S. Congress passed the Jones Act, which amended the Foraker Act, granting U.S. citizenship to all Puerto Ricans, among other things. The Jones Act also established triple tax exemption to all bonds issued by the Government of Puerto Rico or by its counties, municipalities, or other municipal subdivisions. This new triple tax exemption was not (and isn't today) available to any States of the union, making Puerto Rican bonds super attractive to investors. The competitive advantage given to Puerto Rico through these bits of legislation promoted growth in Puerto Rico but made the Puerto Rican government reliant on the issuance of debt. Investors loved the benefits of triple tax exemption and continued to buy Puerto Rican bonds throughout the years, propping up the Puerto Rican economy further.

In 1921, the U.S. Congress passed the Revenue Act providing tax exemption to all U.S. corporations that received 80% or more of their income from U.S. possessions or territories as long as 50% or more of said income came from non-passive business activities in the territories. These bits of legislation further promoted expansion of manufacturing and industrial production in Puerto Rico. The pharmaceutical industry set up shop so to speak in Puerto Rico because of these tax incentives and because of the proximity to the U.S. This helped to improve the economy and increased employment in the island with good high paying jobs.

In 1931, the U.S. Congress adopted Chapter 9 of the Bankruptcy Code, which provided for bankruptcy protection for debt issued by municipalities and instrumentalities of a State, including municipalities and instrumentalities of Puerto Rico. In 1950, the U.S. Congress approved Public Law 600 (P.L. 81-600) providing for Puerto Rico's own local constitution but leaving the substantive provisions of the Jones Act unchanged. In 1976, the U.S. Congress adopted the Internal Revenue Code Section 936, which replaced its predecessor statute Section 901, and converted the prior full federal tax exemption on income earned by Puerto Rican subsidiaries of U.S. corporations to a foreign tax credit. Mainland corporations maintained their local Puerto Rican subsidiaries, promoting economic expansion and employment.

Following this period, Congressional actions led to a steady decline in the Puerto Rican economy, contributing to the current economic and debt crisis. In 1984, the U.S. Congress adopted Section 903(1) of Chapter 9 of the Bankruptcy Code, which included a new definition of “State” that excluded Puerto Rico's municipalities and instrumentalities. Investors of Puerto Rican triple tax exempt bonds loved this because they grew to expect that the issuers of these bonds will never be allowed access to bankruptcy protection available to States in the U.S. under Chapter 9 of the Bankruptcy Code. To add insult to injury, in 1993, President Bill Clinton proposed to phase out Section 936 of the Internal Revenue Code, which, as stated above, helped promote for many years the Puerto Rican economy with a strong and vibrant manufacturing and industrial sectors which were the envy of many parts of the world. In 1996, the Clinton Administration, with the support of the U.S. Congress, eliminated the tax incentives for Puerto Rico. After public pressure from the island, the U.S. Congress agreed to extend the tax incentives with a phase out period of 10 years, expiring in 2006.

Having that historical background, one must wonder if the down spiraling of the Puerto Rican economy was attributed to the elimination of IRS tax incentives under IRC 936? The empirical data from the World Bank suggests that it did have an enormous impact on the island. Following the elimination of the tax incentives in 1996, the gross domestic product in Puerto Rico went from approximately 10% in 2000 to approximately -3.5% (that's right negative 3.5%) in 2006 and then thereafter it has hovered at less than 0% GDP. Hundreds of jobs were lost as Puerto Rican subsidiaries of mainland corporations closed down and moved their operations to Mexico and other Caribbean countries after the passing of trade treaties like NAFTA and CAFTA. Could it be that the U.S. entered into trade agreements with Mexico and other Caribbean countries that took away business activity in Puerto Rico (a U.S. interest) in favor of foreign countries?

Perhaps the economic woes of Puerto Rico is just a streak of bad luck. The 2007-08 U.S. and worldwide credit and mortgage crisis did not really help. Certainly, the impact of the 2007-08 credit and mortgage crisis hit Puerto Rico much worse than it hit the mainland. Thousands of homes were lost, thousands of jobs were terminated, several major banks in the island were taken over by the FDIC, and millions of dollars of wealth vanished. The Puerto Rican economy and real estate markets have still not recovered. Property prices are deeply depressed. The economic woes plaguing the island are compounding massive migration out of the island, leading people to walk away from their homes or sell them at deep discounts in search for a better life and jobs in the mainland. With this mass migration one must wonder where will the tax base come from on the island to help pay for basic services. The unemployment rate in Puerto Rico is 12.4%, double that of the mainland. The recent increase of the sales tax rate to 11.5% from 7% by the government of Puerto Rico is having a minimal effect in raising the necessary funds to pay for basic services and other debts.

On July 1, 2016, $2 billion of Puerto Rican debt comes due. Puerto Rico and its municipalities and instrumentalities owe approximately $72 billion. Public corporations owe somewhere between $20 billion and $25 billion. The Puerto Rican Electric Power Authority (PREPA) owes over $9 billion. Other public corporations include the Government Development Bank and the Public Buildings Authority. Hedge funds hold about $15 billion in Puerto Rican debt, mutual bond funds hold another $11 billion or so, and individuals hold the rest. Many of those investors benefitted from the triple tax exemption provided by the special status of Puerto Rican bonds. These same investor purchased such bonds in reliance on the fact that Puerto Rican substate entities cannot seek the same bankruptcy protections conferred on States since the revisions to Section 903(1) of Chapter 9 of the Bankruptcy Code in 1984.

The rubber is now meeting the road so to speak — that is, the Government of Puerto Rico, recognizing now and maybe for years, its inability to make good on its payment obligations, is seeking the same bankruptcy protections as are currently available to municipalities and instrumentalities of States in the U.S. So, is declaring bankruptcy an option for Puerto Rico? Not without U.S. Congress approval. Since Puerto Rico was removed from the definition of State in 1984's change to Section 903(1) of Chapter 9 of the Bankruptcy Code, Puerto Rican substate entities do not have the ability that they used to (prior to the 1984 change to Section 903(1) of the Bankruptcy Code) to file for bankruptcy protection and restructure its debt. But, rather, Puerto Rico finds itself in the unenviable position of waiting for the U.S. Congress to throw them a life line – the very same people who previously propped their economy up and subsequently snagged from them the important tax incentives and economic measures that made Puerto Rico successful. Picture that imagery for a moment. If Puerto Rico were a State it would not need to rely on Congressional action. Its substate entities could simply file for bankruptcy protection like the City of Detroit did recently. Now, after months of waiting for the U.S. Congress to act — to avert a massive default by Puerto Rico of its debt — the Congress did not act in time and the May debt payment was not made. Everything is pointing to the July 1st payment also being missed. The recent U.S. Supreme Court decision in ( Puerto Rico v. Franklin Cal. Tax-Free Trust, U.S., No. 15-233, 6/13/16 ) (28 BBLR 765, 6/16/16) did not help. The SCOTUS decision effectively preempted Puerto Rico's special bankruptcy law called the Recovery Act, which Puerto Rico adopted as an emergency measure to allow the island to restructure some of its instrumentalities' debt. This is akin to hitting someone when they are down and bloodied.

Speaker Paul Ryan's Congressional Bill H.R. 4900, the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA), which when translated to English means Promise, was finally approved by the House of Representatives last week and is now in the U.S. Senate awaiting approval. PROMESA will allow Puerto Rico's substate entities to declare Chapter 9 bankruptcy and restructure their debt, like the City of Detroit did successfully recently. The bill proposes that a U.S. Congressional Oversight Fiscal Control Board for Puerto Rico be appointed by the U.S. President. One of the 7 appointees to the Oversight Board will be the Governor of Puerto Rico. Ironically and insultingly, the Governor's seat on the Oversight Board is merely symbolic because he does not have a vote. That's seriously absurd, insulting and un-American. Is the island and its people second class citizens? It sure appears to be. The inconsistency in treatment, which some say is discriminatory, of Puerto Ricans, who on the one hand are obliged to sign up for selective military service when they turn 18 and have fought and died in many wars, defending the U.S. and its democratic principles, and, on the other hand, are not allowed to vote in Presidential elections. But, focusing back on the importance of passing PROMESA, the Oversight Board will be charged with restructuring Puerto Rico's debt in a Congressionally made super-Chapter 9 bankruptcy and supervising and managing the ensuing budgets for the island. In a typical Chapter 9 bankruptcy, the debt of a State could not be restructured, just the debt of its municipalities or instrumentalities, while PROMESA, if adopted into law, would allow Puerto Rico's debt (not just the debt of its municipalities and instrumentalities) to be restructured. That's a huge advantage for Puerto Rico and a good lifeline for the island, giving it much needed relief from the choke of its debt.

Not all provisions in PROMESA are perfect. I would eliminate the reduction of minimum wage to $4.50 for young workers and I would provide voting power to the Governor. The people of Puerto Rico deserve respect during this crisis and after, just like the City of Detroit was given the respect to restructure its debt allowing the City to rebound. The people of Puerto Rico are U.S. citizens. They should not be treated like second class citizens. Puerto Ricans should learn a very important lesson from this debt and economic crisis – statehood is not just a privilege, it's a necessity. Having a seat at the table with a vote is more important than anything else. If Puerto Rico were a State, it would have voting representatives in the Senate and House of Representatives that could influence the outcome of many decisions that impact the island. The current non-voting Resident Commissioner is an anomaly. The people of Puerto Rico, who for many years did not want to change the status of the island from a commonwealth to a State, may now be more inclined to vote in favor of switching to statehood as a result of this debt crisis. The last plebiscite in 2012 resulted in over 61% of the residents of Puerto Rico voting in favor of statehood. However, the U.S. Congress did not act to make Puerto Rico a State. Congress is the only one authorized to change Puerto Rico's status to statehood. Political and economic considerations have impeded Puerto Rico from becoming the 51st State of the union.

The U.S. Congress should stop wasting time and act to pass PROMESA. This is your constituency too. The U.S. Congress should make Puerto Rico the 51st State of the union.

(Correction: A paragraph describing restrictions on international shipping carriers under the Jones Act as they apply to Puerto Rico has been removed. The paragraph mischaracterized the relevant provisions.)

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