First Circuit Bars Puerto Rico’s Municipal Debtors From Bankruptcy Court

Puerto Rico’s government has repeatedly issued bonds to finance government obligations and operations, and fund needed infrastructure improvements. Current estimates of the government’s total indebtedness run as high as $72 Billion. The Puerto Rico government has issued two different types of bonds. The first type, general obligation bonds, were issued by the Commonwealth government and secured by its full faith and credit. Under Article VI section 2 of the Puerto Rico Constitution, these bonds must be paid by the government prior to any other government obligation. The second type, project bonds issued by several public entities such as the Electric Power Authority (“PREPA”), the Aqueducts and Sewer Authority (“PRASA”) and the Highway and Transportation Authority (“PRHTA”) (“Public Corporations”), constitute the majority of Puerto Rico’s outstanding bond indebtedness and are not covered by the Constitution’s payment priority clause.

Puerto Rico’s economy has been in recession for the last ten years, and tax revenues have plummeted. By early 2014, it became clear that the Public Corporations were essentially insolvent and unable to pay their bonds. In June of this year, Puerto Rico’s governor announced that the current debt was “unpayable” and hinted at the possibility of default.

A public corporation or municipality in the United States in a similar situation would be able to restructure its debt obligations under Chapter 9 of the U.S. Bankruptcy Code. The Public Corporations, unfortunately, were unable to seek Chapter 9 protection. In a change from long established prior law, 1984 amendments to the Bankruptcy Code (11 U.S.C. 101(52)) include Puerto Rico and the District of Columbia in the definition of “State” “except for the purpose of defining who may be a debtor under Chapter 9 of this title.” This effectively bars Puerto Rico public debtors from access to Chapter 9 proceedings.

In an attempt to create an alternate restructuring mechanism for the Public Corporations, the Puerto Rico Legislature, in June of 2014, passed the Puerto Rico Public Corporations Debt Enforcement and Recovery Act (“the Act”), which created a restructuring process similar to Chapter 9, but with different creditor protections.

The Federal Litigation

Shortly after passage of the Act, two groups of PREPA bondholders holding approximately $2 Billion in bonds filed an action in Federal District Court in Puerto Rico seeking declaratory relief on the grounds, among others, that the Act was preempted by the Federal Bankruptcy Code and was, therefore, unenforceable. The plaintiffs won in the district court and the case was appealed to the 1st Circuit, which affirmed on July 16, 2015.

In doing so, the First Circuit described the issue as a narrow one: whether Section 903(1) of the Bankruptcy Code preempted The Act. The answer to that question, the Court noted, turned on whether a change to the definition of a “State” in the Bankruptcy Code rendered Section 903 (1)’s preemptive effect inapplicable to Puerto Rico. In articulating its answer, the First Circuit noted that the legislative history of Section 903(1) made it clear that it was essentially identical to its predecessor, Section 83(1) of the Bankruptcy Act, which clearly barred Puerto Rico (and all the other territories) from enacting their own versions of Chapter 9.  The Court then concluded that Section 903(1) preemption still applied to Puerto Rico in spite of the change in the definition of “State” in 1984. This conclusion was mandated by the fact that this change did not, by its text or history, change the applicability of Section 903(1) to Puerto Rico.

Congress’ total lack of articulation of any basis or policy reason for overturning long established law is striking.

Judge Torruella, in a lengthy concurring opinion, agreed with the majority that the Act was invalid because it contravened Section 903(1) of the Bankruptcy Code. He went on to say, however, that the 1984 Amendment to the Code which removed Puerto Rico from access to Chapter 9 proceedings was itself invalid. He cited two reasons for his conclusion: that the amendment attempted to establish bankruptcy legislation that was not uniform with regards to the United States, thus violating the uniformity requirement of the Bankruptcy Clause of the Constitution and that the amendment contravened both the Supreme Court’s and the First Circuit’s jurisprudence in that there existed no rational basis or clear policy reasons for their enactment.

Judge Torruella is right. Congress’ total lack of articulation of any basis or policy reason for overturning long established law is striking. More critically, by including Puerto Rico and the District of Columbia as a “state” for purposes of the Bankruptcy Code, but excluding them from access to one of its chapters, Congress has indeed created a bankruptcy system that is not uniform throughout the United States. The Puerto Rico government should consider litigation challenging the constitutionality of section 101(52). Unfortunately, given Puerto Rico’s current economic situation, even an eventually successful challenge of this provision (which would probably reach the Supreme Court) might not come in time to prevent a major default.

The Aftermath

Franklin California Tax Free Trust left the government of Puerto Rico without a legal process through which the Public Corporations (or any other public entity) can restructure their debts. Unlike similar entities with the states, they cannot restructure their debts through the Federal Bankruptcy process and have no access to any alternate state legal process.

A number of mostly negative events have occurred since this decision:

  • Puerto Rico is currently unable to borrow any new funds in the markets.
  • Puerto Rico’s Resident Commissioner in Congress has introduced legislation seeking to remove Section 101(52)’s prohibition on Puerto Rican public entities seeking Chapter 9 protection. At this point, it is highly uncertain whether this proposed legislation has a chance of being passed.
  • On August 3, 2015, the Government Development Bank missed a $58 million payment due on several project bonds. As a result, the price of Puerto Rico bonds in the financial markets plummeted. The Bank attributed this decision to a failure by the legislature to appropriate the required funds.
  • On September 2, 2015, PREPA reached what was described as “a rare agreement” with a group of its bondholders to restructure as much as $5.7 Billion in bonds. Under this agreement, bondholders will lose 15% of their principal and PREPA will receive interest rate relief and a five-year payment moratorium. This agreement covers only a minuscule portion of Puerto Rico’s outstanding bond debt.
  • On September 5, 2015, the government of Puerto Rico announced a five-year plan for restructuring its debts. This plan would restructure about $47 billion of Puerto Rico’s debts through voluntarily reduced payments, the amount of which would be negotiated. The plan also called for a series of economic reforms, including seeking a waiver from increases in the Federal minimum wage, cutting health care costs, and contracting for-profit companies to run government properties. To be implemented, this plan will require major concessions from creditors, the Federal government, and possibly Congress. Press reports to date indicate that the immediate reaction from creditors has been far from positive.
  • On September 22, 2015, PREPA reached a second agreement to restructure $700 million in mature debt. The agreement provides that bondholders may convert their debt into term loans with a fixed 5.75 percent annual interest for a fixed six-year term or exchange all or part of their debt for new PREPA bonds. Unfortunately, these two PREPA agreements encompass only a limited portion of its outstanding debt.

In the absence of Congressional action or a much more substantial agreement among its creditors, Puerto Rico will, in all probability, simply run out of funds and become the first US jurisdiction to default on all its bond debt. This default could have a major negative effect on the U.S. municipal bond market.

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