by Gil Hall, email@example.com @gillamhall
Revised significantly 20160205 1049 AST.
On the third day of the Walmart vs. Puerto Rico trial (Thursday), Walmart called an expert witness with experience in restructuring governmental and nonprofit organizations.
In addition to current work on restructuring efforts in New York state, Martha “Martie” Kopacz explained that she was appointed by Judge Stephen Rhodes as his independent expert in the Detroit Chapter 9 bankruptcy case.
Shawn Rabin, one of Walmart’s attorneys, started by asking Kopacz, for the definition of “insolvent.” She indicated that there were at least two different and important distinctions to the general definition: the term as applied to municipalities and the term as applied to the US Bankruptcy Code.
Based on her analysis of current events in Puerto Rico, Kopacz stated in her formal report that “Puerto Rico is insolvent and, as such, which obligations it chooses to make [payment on] are uncertain.”
When asked by Sean Rabin, one of Walmart’s attorneys, to name the areas she had studied to come to this conclusion, she listed four:
1. Liquidity position
2. Access to financial markets for borrowing
3. Review of defaulted obligations
4. Priority of payments government has designated for use as the official priority and policy for disbursements.
Rabin read aloud for the court a quote from Melba Acosta’s United States Senate testimony in September 2015:
“The fiscal, economic, and liquidity crisis in Puerto Rico has passed the tipping point. The Legislative Assembly has declared a state of emergency, Puerto Rico has lost access to the capital markets on sustainable terms, and Puerto Rico faces an economic and liquidity crisis beyond what any jurisdiction in the United States has faced in generations.”
Rabin asked Kopacz if, based on her extensive professional experience, she believes Puerto Rico’s crisis is, in fact, the worst in generations.
“I absolutely agree with Acosta,” she said. At present the “operational budget has to be used to pay debt and can’t be used to provide services.”
Walmart’s attorney asked the witness what she believes will happen in June 2016 when $700 million on the general obligation bonds come due.
The witness answered: “the Commonwealth will default.”
Rabin then showed Kopacz a heretofore confidential balance sheet purportedly used by the governor’s Working Group for the Fiscal and Economic Recovery (“Working Group”) in the creation of the Fiscal and Economic Growth Plan (“FEGP”), the most recent version of which was released in January 2016. Rabin asked for her conclusion on the report. “The Commonwealth and GDB are out of cash,” she said.
Rabin asked the witness about a draft of the “going concern memo” that was discussed in Tuesday’s trial. She commented: “it is confirming to me in terms of my view that the Commonwealth is insolvent.”
Kopacz added that until Puerto Rico has a credible plan of action and convinces the market it is responsible, the muni market will remain closed to Puerto Rico
Discussion turned to the a series of documents in which the administration of Alejandro García Padilla has laid out the priority of payment for its obligations. When asked about the document the witness said: “restructuring is inevitable.”
Before Kopacz was turned over for cross examination, counsel asked a question that allowed her to sum up her testimony. “Puerto Rico is insolvent. Whatever debt it chooses to pay is uncertain,” she said.
In its cross-examination, Puerto Rico attempted to prove that the witness did not have sufficient data to reach a reasonable conclusions
Acting as the attorney for Puerto Rico, attorney Caroline C. Setliffe sought to compare Kopacz’s work in Detroit–in which she produced multiple documents of many hundreds of pages over the course of years–with her relatively short analysis of the situation in Puerto Rico. The witness became somewhat exasperated with Setliffe, who cycled through the same questions multiple times, each iteration’s being only slightly different than the previous.
The witness was asked if she used other experts’ reports in coming to her conclusion on Puerto Rico, and if it was normal practice to do so. She stated that, yes, she did and that, yes, it was normal to do so. In an engagement like this, she said, it was her practice to talk to as many stakeholders as possible, to read as much material as possible, and then, finally, carefully consider the information in its totality before reaching her own conclusion.
The attorney for Puerto Rico asked Kopacz what she believed people will say about her report for this trial in ten years. The witness replied: “people will look back at February 2016 and say Puerto Rico was insolvent. Absolutely.”
In a final set of questions, Puerto Rico’s attorney asked if the witness had considered what a loss in this case would mean to Puerto Rico’s finances.
Witness said, no. If the AMT tax at question is, in fact, determined to be illegal, then Puerto Rico “would have no right to rely on revenue it’s not entitled to to pay for essential services.”
Setliffe Indicated she had no further questions, and Kopacz left the witness box.
Puerto Rico Treasury Secretary Zaragoza testifies
The second witness called to the stand by Walmart was Puerto Rico’s Secretary Juan Zaragoza. Although Zaragoza’s testimony had been eagerly anticipated, in actual fact his answers merely supported most of the claims Walmart had already introduced during examination of other witnesses.
Perhaps the most interesting and damning statement made by Zaragoza was that that the Puerto Rico Treasury Department is only now processing all of the 2013 tax returns. As such, all of the data Zaragoza was able to cite were thee years old.
Walmart’s attorney Neal Manne opened by asking Zaragoza if he faulted Walmart for bringing the case. “No,” he said, “it’s their right.”
When queried as to whether or not Walmart had ever been suspected of failing to pay the taxes it owed in Puerto Rico, the secretary said: “they were not in the list of companies we were concerned about.”
Manne asked the secretary if the AMT tax proposals made in Act 72 in spring 2015 were purely to raise revenues. “That’s right,” Zaragoza answered.
To the issue of fairness–whether or not the transfer taxes being proposed–were carefully considered to create a fair, equitable alternative minimum tax, Zaragoza said that the Treasury had hired PriceWaterhouseCooper to do an analysis of transfer pricing shortly after February 2015.
The secretary indicated that PricewaterhouseCoopers (PWC) had only recently delivered this analysis.
Walmart’s implication seemed to be that the data necessary to create a fair transfer tax became available long after Act 72 was passed. Thus the tax change had been made out of haste, not careful consideration.
The court adjourned for lunch.
On reconvening, Walmart’s attorney Neal S. Manne showed the witness a letter written by United States Treasury Secretary Jacob Lew to House leader Paul Ryan dated January 15, 2016.
Manne quoted part of the letter to the witness. A rapid series of questions and answers followed. Zaragoza was asked if he agreed with Secretary Lew on a number of points:
Is Puerto Rico in crisis?
Is Puerto Rico in default?
Has Puerto Rico been shut out of the municipal bond market?
Without debt restructuring, will Puerto Rico default on general obligation bonds this year?
Zaragoza answered yes to each question.
Manne asked Zaragoza if it was true that the revenues for the first half of the current fiscal year had proved to be dramatically less than projected.
“Not really,” Zaragoza said. By December 31, 2015 “we were $24 million below projection. The shortfall is attributed to the second half” of the fiscal year.
Manne asked the secretary about Puerto Rico Treasury’s interaction with the Working Group.
Could the witness confirm that the treasury had provided data to the working group? Zaragoza confirmed that it had.
Manne showed the witness the Working Group’s updated document released in mid January 2015. Referencing page four, could the witness confirm that certain specific numbers on that page were provided by the Puerto Rico Treasury. Yes, Zaragoza said, they were.
Was it true that Zaragoza did not expect sufficient revenues in the rest of the fiscal year to yield a positive balance in the Treasury Single Account? Zaragoza said “correct” (presumably meaning that revenues would NOT be sufficient).
Manne showed the witness an English translation of the “Fiscal Sustainability Act” (AKA Act 66 of 2014) http://www.bgfpr.com/documents/PoliticaparasometerconsultaalBGFatenorconlaleynum66-2014.pdf
Manne: are you familiar with this document?
Manne: Is it true that the act prevents Treasury from paying more than $3 million on a single court award in a year?
Manne noted that it would, therefore, take 43 years for a taxpayer owed a $130 million judgement–the amount Walmart claims it would pay in AMT over a three-year period (the minimum timeframe for a trial to conclude in a Puerto Rican Court)–to be fully repaid.
Not necessarily, said Zaragoza. A taxpayer in that situation could conceivably take a tax credit in following tax years for part or all of that amount.
Manne moved on to the Targeted Liquidity Report that had been introduced the day during Melba Acosta’s testimony.
Manne asked for confirmation that Zaragoza had received the report from the Oficina del Comisionado de Instituciones Financieras (“OCIF,” which is the regulatory agency that oversees Puerto Rican banks) and asked if the report indicated that the GDB is insolvent.
Zaragoza confirmed that he had, and that it was.
Manne moved on to the subject of the Commonwealth’s Audit for fiscal year 2014, which is overdue by at least a year and a half.
Wasn’t it true, Manne said, that KPMG couldn’t complete its audit because the Puerto Rican government had not provided all of the necessary documents KPMG needs to do so.
Zaragoza reluctantly confirmed that was correct.
Manne showed the witness the “going concern memorandum” that the PR government has drafted. This memorandum is one of the key documents KPMG needs finalized before it can complete the audit.
Manne asked, hypothetically, if KPMG did not receive the necessary documents, then audit would remain incomplete indefinitely. Zaragoza replied “yes”.
Manne quoted from the memo: there “may be substantial doubt about a government entity’s ability to remain as a going concern”, referring to the Government Development Bank of Puerto Rico.
Referencing page 21 of the draft, Manne read: “if the GDB is not in sound financial condition … the [Puerto Rico] secretary of the Treasury may file a petition in a Puerto Rican Court” asking for receivership.
Zaragoza confirmed that was correct.
Referencing pages 21 and 22, Mann asked: isn’t it true that “the Commonwealth is dependent on a small number of corporate taxpayers to generate a significant amount of tax revenue?”
Zaragoza replied: “I never considered Walmart as one of those [corporate taxpayers].”
Referencing pages 22 and 24 of the memo (a section titled term “external matters”), Manne quoted: “There is significant doubt about Puerto Rico’s ability to continue as a going concern.”
Do you agree, Manne asked. Zaragoza said he did agree.
What followed was a somewhat convoluted series of questions about the precise nature of the relief that Puerto Rico is seeking in federal court. Specifically, that Walmart is seeking an injunction to prevent the enforcement of the tax, and a declaratory judgment clarifying Walmart’s rights.
Manne walked the witness through another, specific legal case–now completed; the name of which I did not catch–that was similar to Walmart’s, but which went through the Puerto Rican judicial system instead of federal court.
Manne noted that at the trial court level and at the appeals’ court level, the Puerto Rican judges involved had expressed adamantly–sometimes, he said, using bold fonts to emphasize their point–that an injunction and declaratory judgment are not available to a taxpayer in such a situation. Rather, the taxpayer must pay the tax and file an administrative complaint. The taxpayer must continue to pay the tax during the entire administrative process. Which, as Walmart’s expert had testified earlier, would take a minimum of three years.[Note: if Walmart went through the Puerto Rican court system, it would not be able to seek relief in the federal courts.]
Walmart ceded the witness to Puerto Rico for cross examination.
As has been the case for the entire trial, the attorneys for Puerto Rico–led by Susan E. Seabrook–took an odd path with their questioning. Seabrook argument seemed to be that the general fund of Puerto Rico was under great strain when Act 72 was passed last spring, and that there had been some very difficult choices that had to be made, on the revenue side and on the expense side. In addition to financial pressure, there were also time constraints (if a budget is not approved by a certain date, Puerto Rican law dictates that the prior year’s budget shall be used).
Puerto Rico’s constitution requires a balanced budget, and the $125 million dollar gap between revenues and expenses had to be bridged.
Zaragoza said that expenses had already been cut from $10.4 billion to $9.8 billion, and that there was nothing more to be done on the expense side.
On the revenue side, he said there were four options:
1. Tariffs. But tariffs don’t go into the general fund.
2. Consumption tax could be raised from 11.5% to 12%, but the legislature wouldn’t go along with that.
3. Individual income taxes could be raised. But that wasn’t an option, since those had just been lowered; the legislature wasn’t willing to yo-yo on the matter.
4. Corporate taxes.
Since options one through three were not politically palatable options, the solution had to be found in corporate taxes. An AMT was discussed, Zaragoza said, because it was a fair computational tax that could be offset by sufficient income taxes.
A discussion between Seabrook and Zaragoza followed regarding Treasury Department’s staffing levels and work experience.
Zaragoza explained that most of his auditing staff are junior level employees who do not have sufficient experience or knowledge to do the sophisticated types of corporate audit that some had suggested for Walmart.
“Right now,” Zaragoza said, “I have half the employees I had in 1992 when I was Assistant Secretary [of the Treasury]”
Puerto Rico said it had nothing further, and the witness was dismissed.
The trial will continue at least through Friday.