Speed read

While the eyes of the world are fixed on the events unfolding in Greece, another sun-drenched, troubled economy is struggling with debt much closer to the United States.

This note provides some preliminary information relevant to credit default swaps (CDS) referencing Puerto Rico and a roadmap for settling municipal CDS (Muni CDS).


On June 29, Puerto Rico's governor Alejandro García Padilla made headlines when he announced in an interview with The New York Times that Puerto Rico would be unable to repay its approximately $72 billion in debts and would seek significant concessions from its creditors.[1] According to The New York Times, the debt restructuring sought by Governor Padilla could include the deferral of debt payments for up to five years or the extension of repayment schedules.

If Puerto Rico restructures or fails to make a payment on, its debt obligations, holders of CDS referencing Puerto Rico may be affected. If this issue is referred to the International Swaps and Derivatives Association, Inc. (ISDA) Credit Derivatives Determinations Committee (DC), this would be the first time that the DC would consider whether a Credit Event has occurred with respect to Muni CDS and could result in the first settlement auction for Muni CDS.

Upcoming Payments

Puerto Rico is among the largest issuers of municipal bonds in the United States.[2]Approximately $25 billion of Puerto Rico's public sector debt is owed by public authorities and enterprises, including the state-owned water and sewer utility, electric power authority and highway authority, and some of this debt is guaranteed by the government of Puerto Rico.

Several upcoming payments could force Puerto Rico to either negotiate a debt restructuring (potentially triggering a Restructuring Credit Event), or, if an agreement to restructure cannot be reached, fail to pay scheduled principal or interest (potentially triggering a Failure to Pay Credit Event). For example, the Government Development Bank has a payment of $140 million of bond principal on August 1, 2015, which is guaranteed by the Commonwealth of Puerto Rico.[3]

In addition, the Commonwealth of Puerto Rico must pay approximately $93 million each month towards its general obligation bonds.[4] These general obligation bonds are protected in Puerto Rico's constitution as senior to all other expenses, including obligations to pay pensioners and public employees. Restructuring these general obligation bonds may be an element of the government's restructuring plan, but The New York Times notes that "[n]o American state has restructured its general obligation debt in living memory."[5]

CDS Referencing Puerto Rico

CDS referencing Puerto Rico generally incorporate the Muni Supplement. In 2014, ISDA published the 2014 ISDA Credit Derivatives Definitions; however, CDS incorporating the Muni Supplement were excluded from the 2014 ISDA Credit Derivatives Definitions Protocol and ISDA has not published an updated version of the Muni Supplement to incorporate the 2014 ISDA Credit Derivatives Definitions. Consequently, the 2003 ISDA Credit Derivatives Definitions, as amended by the Muni Supplement, generally apply to CDS referencing Puerto Rico.

The DC for the Americas region will be responsible for determining whether a Credit Event has occurred with respect to Puerto Rico.[6] While no DC has ever been asked to determine whether a Credit Event has occurred with respect to Muni CDS, a restructuring of Puerto Rico's obligations or a failure by Puerto Rico to pay its debt (or debt that it guarantees) may require the DC for the Americas region to make such a determination and potentially oversee the first Muni CDS settlement auction. The DC and market participants would likely face a number of interesting interpretative questions in the context of CDS referencing Puerto Rico.

Any counterparty to a CDS referencing Puerto Rico (or a clearing house with an open interest in such CDS) may request that the DC for the Americas region convene to determine whether a Credit Event has occurred with respect to a Reference Entity by submitting a question and Publicly Available Information that reasonably confirms the facts relevant to the determination that the Credit Event has occurred. If at least one Convened DC Voting Member of the DC agrees to deliberate the question (or if the question is presented to the DC as a General Interest Question, at least two Convened DC Voting Members agree to deliberate), the DC will convene to determine whether a Credit Event has occurred with respect to the Reference Entity. A supermajority vote of the DC (at least 80% of those participating) is required to resolve that a Credit Event has occurred.

It is not a foregone conclusion that an Auction will be held, as it is unclear whether Puerto Rico CDS trade in sufficient volume to automatically trigger an Auction under the DC Rules. The DC Rules provide for purposes of Muni CDS that if 3 or more dealer members are party to 300 or more CDS transactions, holding an auction will be mandatory.[7] However, it may be difficult to find a sufficient number of market participants to act as dealers for an Auction given that the number of dealer banks trading CDS referencing Puerto Rico is small. If no Auction were to be held, market participants would default to the fallback settlement method (for CDS on the standard Muni CDS Transaction Type, Physical Settlement).

Unique Obligation Characteristics and Deliverable Obligation Characteristics

While the mechanics of a Credit Event determination for Puerto Rico would be similar to other Credit Event determinations, the Credit Derivatives Physical Settlement Matrix contemplates three separate Muni CDS Transaction Types, each of which has a different set of Obligation Characteristics and Deliverable Obligation Characteristics.

Depending on the Transaction Type applicable to the relevant CDS, one of the following additional characteristics will apply as both an Obligation Characteristic and a Deliverable Obligation Characteristic: Full Faith and Credit Obligation Liability, General Fund Obligation Liability or Revenue Obligation Liability. The application of this additional characteristic could limit the types of obligations of Puerto Rico that can be used to trigger a Credit Event determination or that can be delivered or valued in an Auction.

The Muni Supplement also incorporates a definition of "Double-Barrel Obligation Liability" and "Full Faith and Credit Component" and amends the definition of "Not Subordinated" to clarify that where a bond is supported by both a general obligation and a specific revenue source, the Not Subordinated Deliverable Obligation Characteristic only applies to the Full Faith and Credit Component of such Double-Barrel Obligation Liability.

Grace Period

A market participant who is considering triggering CDS protection based on a Failure to Pay Credit Event will need to consider when the Commonwealth of Puerto Rico is required to make a payment under a relevant guarantee, which may depend on the grace period applicable to the underlying debt obligations guaranteed by the Commonwealth of Puerto Rico, as well as any grace period applicable to the guarantee itself. For obligations issued by the Commonwealth of Puerto Rico, it will be necessary to determine whether a grace period applies under the terms of those obligations.

Restructuring Credit Event

Muni CDS specify "Old Restructuring" as a Credit Event. Under the 2003 ISDA Credit Derivatives Definitions, Old Restructuring requires a Credit Event Notice to be sent following a DC Credit Event Announcement to trigger Settlement. However, the Muni Supplement amends the 2003 ISDA Credit Derivatives Definitions to provide for settlement without delivery of a Credit Event Notice following a DC Credit Event Announcement.

Enabling Acts

Muni CDS specify All Guarantees as applicable, which means that a guarantee of public authority debt by the Commonwealth of Puerto Rico will only constitute an Obligation if such guarantee is a Qualifying Guarantee. Determining whether a statutory guarantee is a Qualifying Guarantee would require legal analysis of the Commonwealth of Puerto Rico's enabling acts. Therefore, in addition to reviewing the Deliverable Obligation Characteristics applicable to the underlying debt obligations of the relevant authority and the guarantee, the DC may need to consider whether the statutory guarantees satisfy the criteria for a Qualifying Guarantee under the 2003 ISDA Credit Derivatives Definitions.

Chapter 9 of the U.S. Bankruptcy Code

While recent years have seen several successful municipal bond restructurings in the U.S., the Commonwealth of Puerto Rico and its public authorities are not eligible as debtors under Chapter 9 of the U.S. Bankruptcy Code. Chapter 9 (Adjustment of the Debts of a Municipality) provides protection to financially-distressed municipalities and other subdivisions and instrumentalities of a 'state.' However, Puerto Rico does not qualify as a "state" under the U.S. Bankruptcy Code and is therefore excluded from these protections. In addition, Puerto Rico is not eligible to be a debtor under chapters 7 or 11 of the U.S. Bankruptcy Code, as "governmental units" are not covered by these chapters of the U.S. Bankruptcy Code.

A bill to amend the U.S. Bankruptcy Code to treat Puerto Rico as a state under Chapter 9 was introduced in Congress in February 2015.[8] Following Governor Padilla's interview with The New York Times, Senator Charles Schumer of New York announced that he would introduce companion legislation in the Senate.[9]