Insurance companies that guarantee Puerto Rico municipal debtfiled a lawsuit challenging the commonwealth's decision to divertrevenue designated for some bonds to pay other creditors.

Ambac Financial Group Inc. and Assured Guaranty Ltd. said theclawback of revenue pledged to bond issues violates the U.S.Constitution by interfering with debt-holders' contractual rights.The suit filed in U.S. District Court in Puerto Rico seeks to havethe clawback declared unlawful and asks the court to issue aninjunction against implementation, according to a statement.

“This may well just be the beginning,” Mark Palmer, amanaging director at BTIG LLC who analyzes Puerto Rico andmunicipal bond insurers, said Friday. Bond insurers and investors“are going to use every means at their disposal to hold Puerto Ricoto the letter of the law.”

Puerto Rico Governor Alejandro Garcia Padilla announced inDecember that the commonwealth would divert the revenue in order tofund its general-obligation debt payments, which have the highestpriority under the island's constitution. Puerto Rico defaulted onabout US$37 million in agency bond payments at the start of theyear, saying it would focus on providing essential services as thecommonwealth's financial situation worsened.

“The commonwealth has committed itself to a 'scorched earth'strategy of blaming its fiscal and structural problems on lenders,Congress, and others, in an effort to deflect responsibility andobtain retroactive application of bankruptcy laws,” Nader Tavakoli,chief executive officer of Ambac, said in the statement lateThursday.

The insurers are the first to sue over the diversion. They claima clawback can be implemented only if the commonwealth's funds areinsufficient to cover general-obligation debt service. Puerto Ricoestimates approximately $9 billion of available resources in thefiscal year ending June 30, 2016, which vastly exceeds debt serviceon the public debt of approximately $1.85 billion, according toAmbac. Judge Jose Antonio Fuste will preside over the case, courtdocuments show.

To help address its debt crisis, Puerto Rico officials haveurged Congress to allow some commonwealth public corporationsaccess to bankruptcy, the same as mainland localities and agencies.That would give the island a legal guideline for how to restructuremuch of its $70 billion of debt. The commonwealth, as well asstates, is prohibited from using bankruptcy to reorganize itsfinances.

“This latest development will force a race to the courthouse,”Garcia Padilla said in a statement Friday. “And with no legalframework to handle this impending litigation crisis, both thecommonwealth and its creditors will soon face the opposite of dueprocess and rule of law. This reality causes great uncertainty forall parties involved.”

Will Puerto Rican Government Return Rum TaxRevenue?

The targeted clawback revenue comes from the Puerto RicoHighways and Transportation Authority, the Puerto Rico ConventionCenter District Authority, and the Puerto Rico InfrastructureFinancing Authority, known as Prifa. Ambac paid $10.3 million ininterest that was due Jan. 1 for the Prifa bonds.

The Prifa default was the second by a Puerto Rico agency. ThePublic Finance Corp. (PFC) in August began missing monthlydebt-service payments because lawmakers failed to allocate thefunds. The PFC also missed a Jan. 1 payment.

Shares of Ambac dropped 9 cents Friday to $12.74, the lowestlevel since the insurer emerged from bankruptcy in May 2013.Assured Guaranty declined 36 cents to $25.15 as of 2:44 p.m. in NewYork.

Financial Guaranty Insurance Co. will pay 22 percent of $6.4million in Prifa interest it insures. Edward Turi, general counselfor FGIC, didn't immediately respond to an email and phone messageseeking comment on the Ambac and Assured Guaranty suit.

Less than two weeks before Prifa's payment default, AssuredGuaranty, along with MBIA's National Public Finance GuaranteeCorp., agreed to restructure $8.2 billion of Puerto Rico ElectricPower Authority debt. While the utility's funds aren't subject toclawback, Garcia Padilla's revenue diversion goes against therestructuring pact, Dominic Frederico, Assured Guaranty'spresident and chief executive officer, said in a statementThursday.

“These actions stand in contrast to the consensual agreementthat we and other creditors recently reached with Puerto Rico'selectric utility, Prepa,” Frederico said.

In a Dec. 29 letter to the governor and his administration, bondinsurers said the commonwealth should return rum-tax revenue toPrifa. The insurers calculate as much as $94 million was redirectedbefore Dec. 1. That's when Garcia Padilla signed an executive orderto begin the clawback.

The Highways and Transportation Authority and the ConventionCenter District Authority said last month that they would usereserve cash to repay investors after Puerto Rico redirected theirrevenue, according to regulatory filings.

–With assistance from Sebastian Tong.

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