How did Puerto Rico manage to incur a monumental debt of $72 billion without raising red flags among the sophisticated investors who continuously bought its bonds? Here associate professor of business Evaluz CottoQuijano points to the role of a tax exemption designed by the US Congress over 100 years ago to finance Puerto Rico’s territorial government by inflating its bond debt instead of appropriating federal funds.



On June 30, 2016, a day before the government of Puerto Rico missed a bond payment, the US Congress and President Obama passed the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA). This statute places the Financial Oversight and Management Board for Puerto Rico in charge of handling Puerto Rico’s debt crisis “[to] provide a method to achieve fiscal responsibility and access to capital markets.”


PROMESA excludes the government of Puerto Rico from the control of the process to restructure the crippling $72 billion debt that could threaten the stability of the US financial institutions (mainly investment companies—hedge funds, closed-end funds, open-end funds—and monoline insurance companies) that bought Puerto Rican bonds.((The amount of the Puerto Rico bond debt is approximately $72 billion, but proof of claims for $35 trillion have been filed in the PROMESA Bankruptcy case according to statements of the Oversight Board’s attorney Brian Rosen at the July 25, 2018, court hearing.)) Its enactment and implementation raise many questions. One, especially, comes to mind: How was such a monumental debt incurred?


In this essay, I discuss issues not addressed in most media coverage of PROMESA and the Puerto Rico debt crisis. This debt crisis, I argue, goes beyond the simplistic narrative of a profligate people redeemed by the intervention of the US government through PROMESA. I propose that the enormity of the Puerto Rican bond debt is the intended result of a US government policy dating back more than a century to finance the operations of its territorial government.((Recently, the PROMESA Bankruptcy judge ruled that the territorial government is a congressional creature.  In re Financial Oversight and Management Board for Puerto Rico, No. 17 BK3283-LTS, Doc # 3503 (July 17, 2018).))


How Was This Debt Incurred?


On May 9, 2018, the Government Accountability Office (GAO) issued the report “Puerto Rico: Factors Contributing to the Debt Crisis and Potential Federal Actions to Address Them,”((The report was commissioned by PROMESA § 410.)) that gave an answer to the question above. It identified and discussed two causes of the Puerto Rico debt crisis: the mismanagement of the government of Puerto Rico and the more than 10-year-long economic recession.((The report downplays the US government’s role in the deindustrialization of Puerto Rico, which has been identified as “the most important factor in Puerto Rico’s growing indebtedness.”))


The two GAO-identified causes focus on the issuer side of a bond transaction: Why did Puerto Rico issue this monumental amount of debt? However, it does not address the other side of the transaction: Why did investors, mainly sophisticated US financial institutions, buy Puerto Rican bonds?((A sophisticated investor has “sufficient investing experience and knowledge [in a particular transaction] to weigh the risks and merits of an investment opportunity.” The US Supreme Court has stated that some investors by virtue of their knowledge are able to protect their financial interest without regulatory assistance. Based on PROMESA Title III Court filings, the following institutional investors, among many others, have been identified as PR bondholders: Aristeia Horizons, Capital Advisors, GoldenTree Asset Management, Old Bellows Partners, Oppenheimer Funds, Scoggin Management, Tilden Park Capital Management, and Whitebox Advisors. See also,; Interestingly, the GAO report identifies—although not as prominently as the two abovementioned causesthe high demand for Puerto Rican debt as an “additional factor [that] enabled Puerto Rico to use debt to finance its deficits.” The report states that this demand was driven by the fact that, under federal law, interest earned on Puerto Rican bonds is “not [subject] to federal, state, or local taxes, regardless of where the investors [reside].”((See in contrast the 2017 GAO Report, at page 19, prominently identifying the triple tax exempt status as a major factor that contributed to Puerto Rico’s high debt level.)) This means that investors in Puerto Rican bonds earned a higher return than those who invested in other issuers’ municipal bonds. For this reason, Puerto Rico’s bonds were widely used to increase the return on investment portfolios. Indeed, a 2013 Morningstar Special Report on Puerto Rico identified “180 funds in Morningstar’s database—representing more than $100 billion in net assets—that boast weightings of 5% or more in Puerto Rico bonds.”  How did a small and underdeveloped island become a darling of the US municipal market?


In 1900, just two years after the US military invasion of the island, Congress and the President passed a law to govern the territory of Puerto Rico. The Foraker Act allowed Puerto Rico and its municipalities to issue bonds to finance its operations. Long before Puerto Rico acquired home rule powers in 1952, the US government had decided that the main source of revenue for the operations of the government of Puerto Rico would be bond financing.


In 1917, a new federal act was passed to govern the territory of Puerto Rico. The Jones-Shafroth Act added the so-called triple tax exemption to the already-awarded power to issue bonds. At that time, the state of the economy of Puerto Rico was dire. Its fundamentals would have never attracted investors’ interest in Puerto Rico bonds. Thus, it was essential to make them attractive to US investors. The triple tax exemption was specially designed for Puerto Rican bonds to achieve that result—and it worked.  It generated the high demand for Puerto Rico bonds that the US government intended.


This effect of the triple tax exemption has been described as “an unfortunate twist of irony, [that] federal law enabled Puerto Rico’s excessive debt accumulation.”((Park S. K. & Samples T. R., Puerto Rico’s Debt Dilemma and Pathways Toward Sovereign Solvency, 54 Am Bus. Law. J. 9, 29 (2017). doi:10.1111/ablj.12094)) However, the excessive debt accumulation caused by the exemption is more the necessary result of requiring a territory (that has been excluded from controlling its economy) to finance its operations through bond debt than the unexpected outcome of a neutral or even benign federal policy.


The triple tax exemption allowed the appropriation of a reduced amount of funds for federal programs in Puerto Rico. The appropriation of federal funds for Puerto Rico is politically controversial because bona fide residents of US territories are not required by federal law to pay federal income tax on income derived from within the territory.((26 U.S.C. §§ 931-937;  After Hurricane Maria, the Chicago Tribune published a letter whose author stated, “Have we heard even a hint from any Puerto Rican official that given what they have received from the federal government, they should now pay federal income taxes? Not a chance.” See also “Puerto Ricans Should Pay Federal Income Taxes.”)) This fact has been used to justify the reduced federal funding for Puerto Rico.((The Hill reports, “Territories are not subject to federal income taxes, and therefore normally receive only 15 to 20 percent of their Medicaid costs from the federal government.”)) The triple tax exemption was the means the US government awarded its territorial government in Puerto Rico to make up for the reduced federal funds it appropriated.


The Puerto Rico debt crisis is a complex problem. Oversimplifying it as a matter of mismanagement of the Puerto Rico government and the consequence of a long-term recession dangerously ignores who holds the power in the territorial relationship—a relationship that the triple tax exemption exemplifies. 

In no other area is this intentional design to limit the amount of federal funds allocated to Puerto Rico more evident than in Medicaid funding.  Puerto Rico has a high number of people living in poverty. Nearly 50 percent of its people receive benefits through the Medicaid program.((The Center on Budget and Policy Priorities states, “A higher proportion of Puerto Rico’s residents are covered by Medicaid relative to the 50 states and DC. In 2012, 46 percent of Puerto Rican residents reported having Medicaid coverage, whereas 18 percent of people in the 50 states and DC reported Medicaid coverage.” See also “Puerto Rico and Health Care Finance: Frequently Asked Questions.”)) However, in 2016 “Puerto Rico’s federal matching assistance percentage for Medicaid [was] set by statute at 55 percent. The federal share would be 83 percent if it were calculated in the same way as for the states.”((Supra note 3 at 26 n. 42. See also Mach at page 24.)) To close this gap Puerto Rico raised the missing funds by issuing bonds.((According to the Urban Institute, “To pay for the cost of public services, including publically funded health care services such as Medicaid, the commonwealth has routinely borrowed money by issuing municipal bonds.” See also Park.)) The GAO report states that a main contributor to Puerto Rico debt crisis is the fact that Puerto Rico borrowed funds to balance budgets. In the case of the Medicaid funding, that debt resulted from and was enabled by both the US policy of limited appropriations for the territorial government and the triple tax exemption.  Indeed, the triple tax exemption has proved so beneficial to the US government that it has become a distinctive feature of the financing arrangements for the operations of the other four US territorial governments.((American Samoa, Commonwealth of the Northern Mariana Islands, Guam, and US Virgin Islands.  See, GAO 18-160 at page 9.))


The triple tax exemption was approved not only to save the US government money, but also to generate revenue for US financial institutions—institutions that were themselves major players in the US expansion in the Caribbean. Diane Lourdes Dick writes:


In 1916 … municipal bonds were the premier investment security because they were exempt from increasingly higher income tax rates. However, the supply of municipal bonds was very low. By ensuring, through federal law, that Puerto Rican public debt would receive the most preferential tax treatment available to municipal bonds, Congress deflected attention away from the fact that the United States had installed an ineffective system of taxation in Puerto Rico, which did not generate sufficient governmental revenue. It also capitalized on the island’s plight by expanding the municipal bond supply for U.S. investors.  

Underwriting and selling Puerto Rican bonds has provided a steady source of revenue for many US financial intermediaries. Some of them have faced and are facing civil and disciplinary actions, arbitration proceedings, and private lawsuits due to their sales practices in connection to Puerto Rican bonds. The extent of their misconduct is so scandalous that even PROMESA commissioned the Oversight Board to investigate the role of US financial institutions in Puerto Rico’s debt crisis.((PROMESA §104(o). But “there are concerns with this investigation due to the close ties some Oversight Board’s members have with some of the institutions subject to investigation.” Likewise, non-bondholder creditors question the Oversight Board’s investigation and have asked for a SEC investigation: “Three members of the FOMB are part of a public finance community that has a competing $60 billion-plus claim — the implication being that the FOMB will favor decisions that pay bondholders first.”))


Today, the exemption that so finely accomplished its intended objective for US interests is a source of concern because of the substantial losses that US financial institutions could face due, in part, to this ingenious financing mechanism. Even the GAO report recommends its modification, though not without cautioning about its impending consequences: the vanishing of sources of revenue to finance the operations of the territorial government of Puerto Rico.


This leaves the US government with two alternatives:


  • Substitute with federal funds the revenue lost due to the modification of the exemption. This option has been already rejected by section 410 of PROMESA, which states that the solution to the debt crisis could not increase the federal deficit.
  • Abolish the territorial status and negotiate with Puerto Rico a phase-in process through which Puerto Rico starts to exercise, for the first time, the needed sovereign powers to manage its economy.

This option has been and is currently being advocated, but until now with no positive result. A case in point is the campaign to permanently exempt Puerto Rico from the application of Section 27 of the Merchant Marine Act of 1920, also known as the Jones Act. This provision increases the costs of importing goods into Puerto Rico. However, eliminating or modifying it has been almost impossible because through this provision Puerto Rico subsidizes the US maritime industry, as the Department of Transportation’s Maritime Administration candidly accepted in a 2013 GAO Report.((“According to MARAD officials, unrestricted competition with foreign-flag operators in the Puerto Rico trade would almost certainly lead to the disappearance of most U.S.-flag vessels in this trade.” GAO Report 13-260 at 24.)) Furthermore, the permanence of Section 27 of the Merchant Marine Act has been defended on the basis of national security concerns.((“Although [the Department of Defense] does not administer or enforce the Jones Act, the military strategy of the United States relies on the use of commercial U.S.-flag ships and crews and the availability of a shipyard industrial base to support national defense needs.”  Id. at 38.)) Interestingly, PROMESA § 410(3) states that the GAO recommendations “to avert future indebtedness of territories” could “not imperil America’s homeland and national security.” Thus, Puerto Rico is—as for the last 120 years it has been—stuck in the territorial status because this is the most convenient status for US interests.


This time, however, it is not only Puerto Rico that is interned in the 19th century territorial status. Through the enactment of PROMESA, Puerto Rico’s creditors, many of them the sophisticated financial institutions that bought and/or guaranteed Puerto Rico bonds, are also trapped in it. Indeed, some Puerto Rico bondholders and insurance companies have loudly complained about the deleterious effects of the territorial status represented by the Oversight Board’s actions toward them.((In re the Financial Oversight and Management Board for Puerto Rico Docket # 913 at page 5; Docket # 461 at page 4; Docket # 3674 at page 3.))


The Puerto Rico debt crisis is a complex problem. Oversimplifying it as a matter of mismanagement of the Puerto Rico government and the consequence of a long-term recession dangerously ignores who holds the power in the territorial relationship—a relationship that the triple tax exemption exemplifies. The exemption that once fueled US investors’ interest in Puerto Rican bonds, for the benefit on both the US government and US financial institutions, is today a contributing cause of their bond losses.


Evaluz Cotto-Quijano is an Associate Professor at the College of Business Administration, University of Puerto Rico, Mayaguez Campus, and during summer 2018 she was Visiting Scholar at the University of Chicago.


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