United States: First Circuit Rules Bankruptcy Code Preempts Puerto Rico's Recovery Act

On Monday, July 6, the Court of Appeals for the First Circuit affirmed the February 6, 2015 order and injunction of the Puerto Rico District Court and held that section 903(1) of the Bankruptcy Code preempts the Puerto Rico Debt Enforcement and Recovery Act (the "Recovery Act"). Franklin Cal. Tax Free Trust, et al. v. Commonwealth of Puerto Rico, et al., (1st Cir. July 6, 2015) (Case No. 15-1218): On February 10, 2015, we reported on the district court's decision holding that the Recovery Act was unconstitutional.

As a result of amendments to the Bankruptcy Code in 1984, Puerto Rico, unlike states, may not authorize its municipalities, including its public utilities like PREPA or PRASA, to seek federal bankruptcy relief under chapter 9 of the Bankruptcy Code. In considering the appeal of the district court's order, the Court first confirmed that it had jurisdiction to consider the bondholders' claims of preemption, that those claims were ripe and that they had become ripe immediately upon adoption of the Recovery Act. The Court then ruled that the Commonwealth's effort to allow its public corporations to restructure their debt by enacting the Recovery Act is expressly preempted by the federal Bankruptcy Code. Rejecting the Commonwealth's arguments that the 1984 amendments made the preemption provisions of section 903(1) of the Bankruptcy Code inapplicable, the Court stated that "§ 903(1) has applied to Puerto Rico since the predecessor of that section's enactment in 1946. The statute does not currently read, nor does anything about the 1984 amendment suggest, that Puerto Rico is outside the reach of § 903(1)'s prohibition. Op. at 4. Because the Court affirmed the district court's order and injunction, the Court declined to consider the Commonwealth's appeal of the district court's order denying motions to dismiss the bondholders' Contracts Clause and Takings Claims. Op. at 21.

Analysis

As previously reported, Article I, Section 8 of the United States Constitution provides that "Congress shall have power . . . [t]o establish . . . uniform laws on the subject of Bankruptcies throughout the United States . . ." U.S. Const. art. I, § 8. The Court noted that the United States Congress has established uniform laws of bankruptcy by its enactment of the Bankruptcy Code and that the Bankruptcy Code applies in the Commonwealth.

History of Chapter 9 and Puerto Rico. The Court examined closely the history of chapter 9, the requirement for state authorization of any chapter 9 filing and the treatment of Puerto Rico municipalities under the Bankruptcy Code. The Court stated that "at least from 1938 until the modern Bankruptcy Code was introduced in 1978, Puerto Rico, like the states, could authorize its municipalities to obtain federal municipal bankruptcy relief." Puerto Rico's status "changed in 1984, when Congress re-introduced a definition of 'State' to the Code." Section 101(52) of the Bankruptcy Code defines State to include Puerto Rico, as it had prior to 1978. However, the new definition excluded Puerto Rico from the definition of State "for the purpose of defining who may be a debtor under chapter 9" of the Bankruptcy Code. Thus, Puerto Rico's municipalities were now "expressly (though indirectly) forbidden from filing under chapter 9 absent further congressional action." Op. at 14-17.

Recognizing that, by virtue of the 1984 amendments, Puerto Rico now lacked the power it once had to authorize its municipalities to file for chapter 9 relief, the Court next considered whether the 1984 amendments altered the preemption provision of section 903(1) without Congress expressly saying so. Section 903(1) of the Bankruptcy Code provides that a State (which for these purposes includes Puerto Rico) may not enact a state law prescribing a method of composition of indebtedness of a municipality that is binding on any creditor that does not consent to the composition. The Court noted that "all of the relevant authority shows that Congress quite plainly wanted a single federal law to be the sole source of authority if municipal bondholders were to have their rights altered without their consent." Op. at 45. The Court further stated: "there is no disputing that the Recovery Act binds creditors without their consent or that it is Puerto Rico's "own version[] of chapter [9]," such that it directly conflicts with § 903(1)'s prohibition of such laws." Op. at 29.

The Court held that the context and history of section 903(1) confirm that section 903(1) "was intended to have a preemptive effect." Op. at 25. The provision derives from its precursor, section 83(1) of the Bankruptcy Act, which Congress enacted to expressly overrule a Supreme Court decision upholding the adjustment of municipal debt in Faitoute Iron & Steel Co. City of Asbury Park, 316 U.S. 502, 513-16 (1942) (state law permitted the adjustment of municipal debt if the city and 85% of creditors agreed).

The Court stated that Congress enacted this provision "to restore what had been believed to be the pre-Faitoute status quo by expressly prohibiting state municipal bankruptcy laws adjusting creditors' debts without their consent." Section 83(1) as recodified in section 903(1) "on [its] face barred Puerto Rico and the Territories, just as [it] did the states, from enacting their own versions of chapter 9 creditor debt adjustment". The re-codification of section 83(1) into section 903(1) "was necessary to maintain the uniformity of the bankruptcy laws by preventing states from "enact[ing] their own versions of chapter IX." Op. at 26-28.

Accordingly, section 903(1) still applies to Puerto Rico in light of the addition of the definition of "State" to the Bankruptcy Code in 1984. The Court held that the definition does not alter the meaning of section 903(1) of the Bankruptcy Code "because 903(1) does not define who may be a debtor under chapter 9 . . . . If Congress had wanted to alter the applicability of § 903(1) to Puerto Rico, it "easily could have written" § 101(52) to exclude Puerto Rico laws from the prohibition of § 903(1)." Op. at 29-30.

Rejection of Commonwealth's Arguments. The Court dismissed the defendants' arguments, including the argument that section 903(1) only applies to creditors of entities that have filed or can file for chapter 9. The Court also rejected arguments that Puerto Rico was in "no-man's land", finding that "Congress preserved to itself that power to authorize Puerto Rican municipalities to seek chapter 9 relief." Op. at 5. In holding that the Recovery Act is preempted by section 903(1) of the Bankruptcy code, the Court rejected following the arguments raised by the Commonwealth:

  • Because chapter 9 does not apply to Puerto Rico, section 903(1) cannot apply to Puerto Rico. The Court held that defendants' interpretation relies on one of two propositions. Either (i) states that do not authorize a Chapter 9 filing are similarly exempted and not barred by section 903(1) or (ii) the availability of Chapter 9 "occupies the field of nonconsensual municipal debt restructuring, and §903(1) merely aims to clarify that the operative clause of § 903 does not undermine that background assumption." Op. at 40-42. The Court held that even if the Commonwealth is correct that chapter 9 preempts the field of nonconsensual municipal debt restructuring, the Commonwealth is not able to demonstrate that that preemption does not apply to Puerto Rico. The Court noted that under defendants' interpretation, states could adopt statutory relief for other municipalities that "fail to qualify for municipal bankruptcy protection for other reasons – including, for example, municipalities that are not 'insolvent'." Op. at 42-44. The Court stated that "[t]o exclude such municipalities from the preemptive scope of § 903 would be an absurd result." Op. at 44. The term "State" does not exclude Puerto Rico municipalities from federal relief; rather, it denies to Puerto Rico the authority to decide when they might access it. (emphasis in original) Absent further congressional action, § 903(1) still applies.
  • Because Puerto Rico municipalities cannot be debtors, bondholders are not "creditors" and therefore, the Recovery Act does not bind creditors in violation of section 903(1). The Court stated that construing the word creditor "so narrowly would undermine the stated purpose . . . in prohibiting states from 'enact[ing] their own versions of Chapter [9]' . . . . Under defendants' construction, any state could avoid the prohibition by denying its municipalities authorization to file under §109(c)(2)." Op. at 34-36.

Impact. Following the District Court's February 6, 2015 order and injunction, the Commonwealth has made little public reference to the Recovery Act. Given the current state of play, this ruling will not materially affect negotiations with bondholders at entities like PREPA, PRASA and PRHTA that would have been subject to the Recovery Act. Instead, efforts are underway for Congress to take action. Representative Pedro Pierluisi, Puerto Rico's non-voting member of Congress, in February, 2015, proposed legislation to amend the Bankruptcy Code to allow Puerto Rico to authorize its public utilities and other distressed municipalities to file chapter 9 petitions. H.R. 870, 114th Cong. (1st Sess. 2015). That bill did not gain traction in Congress however. Because of recent events, Senators Charles Schumer and Richard Blumenthal have announced a plan to sponsor a similar bill and various Congressional leaders have indicated support to take action.

Additionally, on July 6, 2015, Congresswoman Nydia M. Velazquez, representing New York's 7th Congressional District, wrote a letter to President Obama requesting that he convene the President's Working Group on Financial Markets "to ensure an orderly resolution" to Puerto Rico's fiscal crisis. (The President's Working Group on Financial Markets consists of the Secretary of the Treasury, the Chair of the Board of Governors of the Federal Reserve System, the Chair of the Securities and Exchange Commission, and the Chair of the Commodity Futures Trading Commission, or their respective designees.)

Finally, the Commonwealth itself has reached out to bondholders to try to restructure its $72 billion of public debt. The Commonwealth has indicated that a moratorium of debt payments may be necessary–a result almost certain to lead to further litigation.

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