(Bloomberg Opinion) -- One of the more enlightening scenes in the recently concluded season of “Billions” came in the second episode, when the team at Axe Capital learns that a Black Swan event has taken place: a tsunami in Brazil.
The traders gather in a conference room and begin listing all the ways they can make money from the disaster.
Then, Ben Kim, Axe Capital’s trader with a heart o’ gold, asks: “Is no one worried about, you know, the people in Brazil?”
If you replace a tsunami in Brazil with a hurricane in Puerto Rico, and swap the fictional Axe Capital for the real-life Aurelius Capital Management LLP, the scene I just described pretty much summarizes the relationship between the island and the hedge fund. Aurelius, which is run by Mark Brodsky, a Paul Singer protege, owns $558 million of Puerto Rico’s general obligation bonds. And Brodsky wants his money back.
That $558 million is part of a larger $17 billion debt that Puerto Rico owes its unsecured creditors — the so-called general obligation bondholders. In addition, it owes $18 billion to a group of secured creditors, known as the Cofina bondholders; they are supposed to be repaid via a sales tax the government imposed in 2006. In all, Puerto Rico owes its creditors, including its pensioners, an astounding $124 billion — a debt it utterly lacks the means to repay, or anything close to it.
That was true even before Hurricane Maria devastated the territory 10 months ago. For more than a decade, the Puerto Rican economy had been in a recession, resulting in a dwindling tax base, a staggering poverty rate of 45 percent, and deteriorating housing stock and infrastructure. Some 500,000 people — almost one out of every seven residents — moved to the mainland. In July 2016, after years of borrowing beyond its means, Puerto Rico succumbed to the inevitable: It defaulted on its general obligation bonds, concluding that it was more important to provide services to its citizens than interest payments to its bondholders. Defaults on all its other bonds soon followed.
As painful as this was for Puerto Rico, it was the bond equivalent of red meat for Brodsky. For years, he had stood shoulder-to-shoulder with Singer, the managing partner of Elliott Management Corp., as they extracted billions in profits from Argentina's bond default (though it did require a 15-year struggle). Their primary weapon was unusually hardball litigation, using U.S. federal courts to tie Argentina up until it was willing to pay something close to what Singer and Brodsky were demanding.
I don’t know for sure when Brodsky started snapping up Puerto Rico’s general obligation bonds — neither Aurelius’s spokesman nor the spokesman for the general obligation bondholders would talk to me — but it is easy enough to understand his rationale. Puerto Rico was going to be another Argentina.
The great advantage Singer and Brodsky had in the Argentina default is that countries can’t file for bankruptcy. Although Argentina cut a deal with most of its bondholders, it had no way to force the holdouts to accept it, the way a judge can “cram down” a settlement in a bankruptcy case. So Singer and Brodsky simply ignored the agreement accepted by the others, and continued their bare-knuckle tactics until they got what they wanted. As for the Argentine population, well, they were never on their list of priorities.
As a territory of the U.S., Puerto Rico also lacked the ability to file for bankruptcy, not even Chapter 9, which cities like Detroit used when they’ve gone broke. One could thus envision an Argentina-like scenario playing out: Brodsky would stay away from any proposed settlement, and play his usual litigation hardball to extract more money than less heartless bondholders.
Except for one problem. Well after Aurelius had loaded up on Puerto Rico’s bonds — but before the island stopped paying interest on its bonds — Congress passed a law establishing the Financial Oversight and Management Board for Puerto Rico. This entity was supposed to oversee the island’s finances, but Congress also gave it the power to conduct bankruptcy-like proceedings if necessary. Which meant it had the authority to force Aurelius to accept pennies on the dollar if it came to that.
The general obligation bondholders first tried to kill the bill. Then they tried to water it down. When those efforts failed, Brodsky and Aurelius, who were among the leaders of the general obligation bondholders, went to their weapon of choice: They filed a lawsuit to have the new board declared unconstitutional. (Their argument was that because the board members had not been confirmed by the Senate, they were in violation of the Appointment Clause of the Constitution.)
Meanwhile the general obligation bondholders sued to have the Cofina bonds declared illegal, seeking to claim the island’s sales tax for themselves. They also claimed that because their repayment was written into Puerto Rico’s constitution, they had to be paid before anyone else. The Cofina bondholders, meanwhile, sued to have some of the general obligation bonds declared illegal. There were also lawsuits brought by — and against — the bond insurers. Basically, by the time Hurricane Maria hit in September 2017, everybody was suing everybody. The goal was to be first in line to get whatever money might ultimately be available to the bondholders.
Did the devastation caused by the hurricane, which killed thousands, destroyed homes and left the island without power, give pause to the bondholders? In some cases, yes. But not Brodsky. The judge overseeing the bondholder litigation, Laura Taylor Swain, called for a litigation time-out in the hurricane’s immediate aftermath, but as soon as it ended, Aurelius pressed on with its effort to have the oversight board declared unconstitutional.
Late Friday, however, Swain ruled against Aurelius. Because the board’s members were territorial appointments, rather than federal appointments, she said, they did not need to be approved by the Senate. The oversight board was constitutional.
This has large ramifications. First, it means that unless Aurelius can get Swain’s decision overturned on appeal, the firm is in a bad spot. In Detroit, unsecured creditors did much worse than secured creditors, and came away from the bankruptcy with billions of dollars in losses. The board could well decide to treat the general obligation bondholders the same way — indeed it may have no choice given Puerto Rico’s dire straits. And suing the board didn’t exactly generate goodwill.
Secondly, while Brodsky was busy pursuing his litigation strategy, the Cofina bondholders took a different approach: They negotiated. In June, they announced a deal that would give them 53 percent of the sales tax revenue, with the rest going to the island. They also laid claim to $1.2 billion that been held aside until the bond disputes got resolved. The senior Cofina bondholders are expected to get between 90 and 93 cents on the dollar. (To be fair, the general obligation bondholders had earlier cut their own deal with the Cofina bondholders. But it was quickly ruled out of bounds because the two entities didn’t have the ability to cut a side deal that didn’t involve the board or the commonwealth.)
Investors are clearly pleased. The Cofina bonds have risen from about 40 cents to 83 cents on the dollar. The general obligation bonds, meanwhile, remain stuck in the low 40s.
There is another issue that makes Puerto Rico different from Argentina: Puerto Ricans are American citizens, and have the ability to move to the mainland. Since the hurricane, more than 100,000 people have left, and the government estimates that more than 10 percent of the population will depart during the next five years. Every departure means less tax revenue for the island — and reduces its ability to pay even a fraction of its enormous debt.
Which is also why Aurelius’s hardball strategy is shortsighted in addition to being cruel. In the past, the general obligation bondholders have called on Puerto Rico to reduce its education spending and sell off public buildings so that they could get paid. Suing to extract money from an impoverished island, and forcing it to pay tens of millions of dollars in legal fees, will only exacerbate its problems, causing yet more people to flee to the U.S., reducing the tax base even more, and making it even less likely that the bondholders will ever get paid.
All of which is to suggest that helping the people of Puerto Rico get back on their feet would not only have been the right thing to do, it would have made a lot more strategic sense for anyone trying to get their money back. But I guess that’s only obvious if you don’t work for a hedge fund.
To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net
Joe Nocera is a Bloomberg Opinion columnist covering business. He has written business columns for Esquire, GQ and the New York Times, and is the former editorial director of Fortune. He is co-author of “Indentured: The Inside Story of the Rebellion Against the NCAA.”
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