ENGLEWOOD (S&P Global Ratings) April 13, 2023--The March 2023 ruling from the U.S. First Circuit Court on Puerto Rico Electric Power Authority's (PREPA) bonds finding that bondholders do not have a lien on future revenues, but rather are limited to what is available in reserve funds, has generated a great deal of attention in the market. Similar to previous First Circuit Court decisions regarding Puerto Rico's bankruptcy, the significance of the ruling could be broad, given how infrequent local government bankruptcies are, but strictly speaking it is only legal precedent in jurisdictions within the First Circuit, including Puerto Rico and the states of Maine, Massachusetts, New Hampshire, and Rhode Island. Our credit ratings are forward-looking opinions about an issuer's relative creditworthiness. They assess the relative likelihood of whether an issuer may repay its debts on time and in full. Therefore, we do not anticipate the ruling will have a direct effect on our ratings or analysis in U. S. public finance. It is also important to note that we do not assign recovery ratings in U.S. public finance.

Credit Fundamentals Are Key In Our Analyses

From S&P Global Ratings' perspective, the ruling underscores that credit fundamentals--S&P Global Ratings' view of an issuer's relative economic, financial, and management performance--remain the primary driver of issue credit ratings. The existence of legal protections in bond documents can inform our opinion of the issuer's incentive and ability to pay its various obligations and may help investors map recovery prospects in a bankruptcy; however, they alone do not drive our credit analysis. As we've observed when an issuer's creditworthiness deteriorates to the point where bondholders' main comfort is to rely on the legal provisions for payment, the situation isn't nearly as straightforward as it may have appeared when the bonds were issued.

Even in circumstances where legal protections provide greater clarity to the order of payments or other features of the bonds' structure, the issuer's underlying credit quality still serves as the primary driver for our credit ratings. Thus, our ratings reflect our opinion of the specific economic, financial, and management performance of a particular issuer ahead of potential legal protections in bankruptcy.

The First Circuit Court's Decision Does Not Prompt Any Changes To Criteria

Our criteria reflect our view that legal constructs and bondholder protections, including those accompanied by legal opinions, must be viewed through the lens of a bankruptcy system that affords broad powers to the municipal debtor and limited powers to the court and remains highly untested. In our view, without a meaningful body of municipal bankruptcy precedent to draw from, statutory liens, special revenue designation, and comparable bondholder protections cannot be reliably translated into meaningful expectations around payment priority or timelines. (See paragraph 76 of "Priority-Lien Tax Revenue Debt," published Oct. 22, 2018.) We believe that, during distress, the risk to full and timely payment of debt is heightened for municipal issuers because these legal protections come into direct competition with other priorities of a municipality, such as maintaining critical services, including public health and safety.

For revenue-backed transactions, such as government-owned utility systems, our criteria consider features of the general creditworthiness of the government as part of the rating process. This can include analysis of fiscal and governance issues, or an assessment of liquidity levels. In some criteria there are caps or overrides that apply to the final rating based on credit characteristics of the related government(s). However, regardless of the criteria used or enterprise revenue pledged, analysis of the general credit quality of the government it services is a critical element of our analyses and our ratings.

The Role Of Legal Protections In S&P Global Ratings' Credit Analyses

We start our analysis from the premise that contracts are enforceable and legal provisions will be followed. Legal protections, whether in bond documents or by operation of law, may strengthen a bondholder's recovery prospects. However, from a ratings perspective, the issuer's underlying credit quality still serves as the primary driver for our credit ratings.

Like a spider web with the operating entity situated at the center, as pressure pulls on the center of the web, all associated issuers and structures are likely to be stretched down to varying degrees, with the government trying to address all competing operating needs and payment obligations simultaneously. Legal protections and opinions alone cannot provide credit enhancement or serve as a substitute for our assessment of credit fundamentals. Legal provisions matter, but for the purposes of our credit rating analysis, we don't rely on them to achieve total separation of a revenue stream from the government pledging it.