(Recasts top, adds details about law, PREPA bonds, background of Puerto Rico's fiscal situation )
By Tim McLaughlin and Lisa Lambert
June 30 (Reuters) - Puerto Rico's troubles continued to worsen on Monday after mutual funds holding about $1.7 billion in its debt sued the commonwealth while other investors sold the bonds on concerns the island's finances could deteriorate further.
The flashpoint for the lawsuit brought by two large institutional holders is a law passed last week that allows Puerto Rico's public corporations - primarily its troubled electric power authority known as PREPA - to restructure their debt. It sparked a sharp selloff in these agency bonds that extended on Monday.
Under its constitution, Puerto Rico does not have the power to enact a bankruptcy law to adjust its debt but island authorities say the entities in question are not subject to that rule. The funds disagree and their reaction raises the possibility of a protracted legal battle over Puerto Rico's obligations to its debtholders.
The law specifically excludes the commonwealth and the Government Development Bank. Still, it has stoked concerns about the potential for a larger restructuring of commonwealth debt.
On Monday, Puerto Rico's financial leadership raced to reassure investors the law "in no way indicates any shift in Puerto Rico's historical and constitutionally supported commitment to honoring its financial obligations."
Standard & Poor's Ratings Service on Friday put the entire commonwealth's general obligation and appropriation debt on Creditwatch with negative implications. On Monday, it added the Puerto Rico Aqueduct and Sewer Authority (PRASA) to the review. That authority has said it will not restructure under the law.
Years of population decline and economic weakness have taken a toll on Puerto Rico, saddling it with about $70 billion in debt and shrinking its revenues. Governor Alejandro Garcia Padilla signed a law declaring a fiscal emergency less than two weeks ago, and this spring, after all three rating agencies had cut its credit score to junk, the territory hired Wall Street restructuring consultants.
On Monday, Padilla blamed the commonwealth's former government administrations for allowing the public corporations to overspend. The government has repeatedly stepped in to help the public corporations.
"My administration is not going to permit our families to suffer because of the wrong decisions of the past nor let old debts restrict the economic revival of the country," he said.
PRASA, PREPA and the Highways and Transportation Authority have a combined $20 billion in debt outstanding.
Moody's Investors Service said on Monday the law shows the commonwealth's "diminished willingness" to support the corporations.
Bond funds run by OppenheimerFunds, a unit of insurer MassMutual Financial Group, and Franklin Templeton, filed an amended complaint against the commonwealth on Sunday in U.S. District Court in Puerto Rico.
Franklin Funds, a unit of Franklin Resources Inc, holds about $907.2 million in revenue bonds issued by Puerto Rico Electric Power Authority. Oppenheimer's Rochester funds hold about $821.4 million in the PREPA bonds, according to the complaint.
The law has spurred a massive sell-off in revenue bonds issued by Puerto Rico's electric authority, the most troubled of the public corporations. In Monday morning trading, PREPA yields reached a record high of 12.627 percent, or 44.85 cents on the dollar.
PREPA is facing the expiration of millions of dollars in lines of credit. If it cannot extend the lines, the Government Development Bank may not have enough cash to keep it afloat. At the same time, it has a bond payment due on Tuesday. David Millar, a Puerto Rico spokesperson, said "the trustee has sufficient funds" to cover it.
Since the law passed, the price of long-dated PREPA bonds, or those maturing in 20 years or beyond, have dropped by about 15 percent, according to the complaint. It added short-dated bonds, those maturing over the next four years, have fallen as much as 40 percent.
Conversely, prices on $3.5 billion junk bonds Puerto Rico issued this year have rallied since the law was introduced on Wednesday because investors now expect the commonwealth would not bail out struggling corporations. On Monday the price of those bonds rose to 90.5 cents, yielding 9.192 percent.
Puerto Rico is one of the largest issuers of municipal bonds. Under its constitution, it cannot enact a bankruptcy law to adjust its debts. The complaint contends Puerto Rico passed an act modeled after title 11 of the bankruptcy code used by corporations to reorganize.
Bond insurers with exposure to Puerto Rico were also hit. MBIA Inc shares fell 4.9 percent on Monday while Assured Guaranty was down 1 percent.
Additional reporting by Karen Pierog in Chicago and Edward Krudy in New York; Editing by Tom Brown and Andrew Hay