The Kobre & Kim debt investigation report on Puerto Rico that we wrote about [last week] establishes a framework for bondholders (and the government) to bring claims against the financial advice industry that participated in the island’s bankruptcy.
But it has important omissions.
The report leaves out any mention of how the underwriters, bond trustees, law and accounting firms, credit agencies and other financial advisers were selected and compensated by the Puerto Rico government.
Granted, the report by Kobre & Kim, that, as we noted the other day is a well-known law firm that “focuses exclusively on disputes and investigations involving international fraud and misconduct,” performs a public service by including a list of said advisers. The Federal Oversight and Management Board (FOMB) for Puerto Rico, which commissioned the report, would do well to order a follow-up report that explores how advisers were selected and compensated.
The existing report includes hints that such an inquiry might be useful. Kobre & Kim imply, for instance, that the government’s choice of bond counsel was based on relationships with the governor rather than who was best for the job.
The Kobre & Kim report does not pursue the line of questioning that point raises, but follow-up questions well worth exploring would include what effect political influence in counsel selection had on payments to law firms, how fees were set, who decided on them, and who checked billings for accuracy.
Was the preferential treatment limited only to law firms or did it metastasize across the board to include accountants, credit-rating agencies and other advisers? And did firms in question support the governor with political contributions or in other ways?
Is there a pay-to-play system?
Put another way, is there a system of pay-to-play in Puerto Rico as seems to be implied by Kobre & Kim, and how has it worked?
The Puerto Rico Energy Commission has previously raised this issue, elevating it from a somewhat speculative matter to a real red flag. In its review of PREPA, the commission found that advisers were chosen without competitive bidding, fees were set by the consultants themselves, excessive spending on such contracts was a problem, and PREPA had little real control over the consultants.
In the end, in one instance, they cost PREPA an estimated $100 million for a bond deal that never even closed. One company, a New York firm called AlixPartners, was paid $40 million to lead that particular effort.
High-priced off-island consultants have cost a struggling U.S. commonwealth hundreds of millions of dollars.
As Puerto Rico’s financial condition deteriorated, its bond deals became more complex. Refinancing and swap deals were used to juggle interest rates. Debt service payments and cash flow drove the deals more than the island’s need for capital for roads, schools, electricity, medical facilities and housing. Rearranging legacy debt —and enriching the advisers—even eventually crowded out the dubious use of bond proceeds for operating expenses and pension obligations.
All of the above created a snowball effect that drove consultant fees higher and higher.
Kobre & Kim has at its disposal the closing documents for each bond deal that hold a considerable trove of information concerning how much the advisers were paid, as in the norm elsewhere. In Louisiana, for example, fee payments for advisers on bond deals are routinely reported to the public by the State Bond Commission as part of the minutes of its public meetings.
A useful follow-up report on Puerto Rico would include one picture worth a thousand words: a chart aggregating fees paid to each advisor under whichever governor was in power at the time. Kobre & Kim could also interview politically appointed government employees to determine how financial advisors were chosen and how their fee structures might have been determined by their relationship with the governor.
A deeper inquiry might also compare campaign contributions from company officials or individuals associated with the consultant firms in question. This information could be especially useful in designing clearer restrictions on government employee participation in political campaigns and fundraising, improved oversight of adviser selection, and public access to fee-setting schemes.
If Puerto Rico is to regain access to bond markets, it needs a completely transparent process, start to finish.