The Commonwealth of Puerto Rico's efforts to deal with more
than $70 billion in debt have been a magnet for media scrutiny
during the last two years. A question frequently asked in
connection with the island territory's struggles to stay afloat
is whether Puerto Rico, as an unincorporated territory of the U.S.,
could resort to a bankruptcy filing as a means of alleviating its
financial problems.
Puerto Rico, however, is statutorily barred from seeking
protection under the Bankruptcy Code. In addition, Puerto
Rico's municipalities and instrumentalities cannot be debtors
under chapter 9. On June 28, 2014, Puerto Rico's governor,
Alejandro García Padilla, attempted to remedy this problem
in part when he gave his imprimatur to legislation that created a
judicial debt-relief process modeled on chapters 9 and 11 of the
U.S. Bankruptcy Code for certain public corporations, including the
Puerto Rico Electric Power Authority ("PREPA"), which has
$9 billion in bond debt. The Puerto Rico Public Corporation Debt
Enforcement and Recovery Act (the "Recovery Act") was
intended to ring-fence Puerto Rico from potential liabilities
arising from defaults by its public corporations and to give the
corporations a framework for restructuring their obligations.
Puerto Rico's public corporation debt-relief initiative was
dealt a severe blow on February 6, 2015, when a federal district
court judge struck down the law as unconstitutional. In
BlueMountain Capital Management, LLC v. García-Padilla, No.
3:14-cv-01569 (D.P.R. Feb. 6, 2015), the court ruled, among other
things, that "[b]ecause the Recovery Act is preempted by the
federal Bankruptcy Code, it is void pursuant to the Supremacy
Clause of the United States Constitution." The ruling, which
has been appealed by Puerto Rico, is a setback not only for PREPA
and other public corporations attempting to restructure their bond
debt (e.g., the Puerto Rico Aqueduct and Sewer Authority and the
Puerto Rico Highways and Transportation Authority), but also for
Puerto Rico itself.
The Recovery Act
As noted, the Recovery Act is patterned on chapters 9 and 11 of
the U.S. Bankruptcy Code (with certain important distinctions) and
is in all practical respects a nonfederal bankruptcy law.
Under the Recovery Act, an eligible public corporation may pursue
two alternatives, simultaneously or in sequence. The first is a
"consensual debt relief transaction" akin to a
prepackaged or prenegotiated chapter 11 case.
To commence such a proceeding, an eligible entity must file a
notice of a "suspension period," which stays collection
actions by all identified creditors for up to 360 days, unless the
entity elects not to seek approval for specified debt relief from a
special Public Sector Debt Enforcement and Recovery Act Court
(created under the Recovery Act). If court approval is requested,
the stay remains in place until either: (i) any court order
approving debt relief becomes final; or (ii) 60 days after the
denial of such relief.
Debt relief may be approved by the court only if: (a) creditors
holding at least 50 percent of the amount of debt within a class of
substantially similar obligations participate in a vote or a
consent solicitation for a proposed amendment, modification,
waiver, or debt exchange; and (b) at least 75 percent of
participating voters approve the proposed relief. Upon approval by
a class of creditors, the applicable debt relief would be binding
on all creditors within the applicable class.
The second avenue for debt relief involves the filing of a
petition with the court by or on behalf of an eligible public
corporation, which triggers an automatic stay banning creditor
collection efforts. This avenue, similar to chapter 11 of the
Bankruptcy Code, provides that the court may approve a debt
adjustment plan if at least one class of impaired debt votes to
accept the plan. A class is deemed to approve a plan if: (i)
creditors in the class holding at least two-thirds of the amount of
the debt involved vote on the plan; and (ii) of the class members
who actually vote, the holders of more than one-half of the debt in
the class approve the plan.
All impaired creditors must receive at least as much under a debt
adjustment plan as they would have received if all creditors had
been allowed to enforce their claims on the filing date of the
petition. Also, each impaired creditor must receive its pro rata
share of 50 percent of the debtor's positive free cash flow, if
any, after payment of certain specified expenses, during the 10
fiscal years following the first anniversary of the plan's
effective date, until creditors are paid in full.
Constitutional Challenges
The Recovery Act's obvious similarities to chapter 9 and chapter 11 of the Bankruptcy Code, as well as the fact that the legislation was not enacted in accordance with the U.S. Constitution, immediately provoked attacks on its constitutionality. Bond funds (collectively, the "Bond Funds") affiliated with Franklin Resources Inc. and Oppenheimer Rochester Funds, which collectively hold approximately $1.6 billion in PREPA bonds, filed a lawsuit on June 30, 2014, in the U.S. District Court for the District of Puerto Rico, alleging, among other things, that the Recovery Act is unconstitutional because the legislation is preempted by chapter 9 of the Bankruptcy Code. Investment fund manager BlueMountain Capital Management, LLC ("BlueMountain"), which holds PREPA bonds and manages funds that hold more than $400 million of PREPA bonds, filed a similar lawsuit seeking invalidation of the Recovery Act on the basis of preemption. The district court subsequently consolidated the two cases.
Preemption
The Bankruptcy Clause of the U.S. Constitution grants authority
to Congress to establish a uniform federal law of bankruptcy. U.S.
CONST. art. I, § 8, cl. 4. The Supremacy Clause of the
Constitution mandates that federal laws, such as those concerning
bankruptcy, "shall be the supreme Law of the Land; . . . [the]
Laws of any State to the Contrary notwithstanding." U.S.
CONST. art. VI, cl. 2. Thus, under the doctrine of preemption,
"state laws that interfere with or are contrary to federal law
are preempted and are without effect pursuant to the Supremacy
Clause." In re Loranger Mfg. Corp., 324 B.R. 575, 582 (Bankr.
W.D. Pa. 2005); accord Hillsborough County v. Automated Medical
Labs, Inc., 471 U.S. 707, 712 (1985). "For preemption
purposes, the laws of Puerto Rico are the functional equivalent of
state laws." Antilles Cement Corp. v. Fortuño, 670 F.3d
310, 323 (1st Cir. 2012).
Through the years, three types of federal-law preemption over
state law have been developed by the courts: (i) express
preemption; (ii) field preemption; and (iii) conflict preemption.
In re Nickels Midway Pier, LLC, 332 B.R. 262, 273 (Bankr. D.N.J.
2005). Express preemption applies "when there is an explicit
statutory command that state law be displaced." Id. Field
preemption applies when federal law "is sufficiently
comprehensive to warrant an inference that Congress 'left no
room' for state regulation." In re Miles, 294 B.R. 756,
759 (B.A.P. 9th Cir. 2003); Hillsborough County, 471 U.S. at 713.
Conflict preemption applies if state law conflicts with federal law
such that: "(1) it is impossible to comply with both state law
and federal law; or (2) the state law stands as an obstacle to the
accomplishment and execution of the full purposes and objectives of
Congress." Nickels Midway Pier, 332 B.R. at 273.
In BlueMountain Capital Management, Puerto Rico and PREPA moved to
dismiss the lawsuits brought by the Bond Funds and BlueMountain,
arguing that: (i) the claims are unripe for adjudication because no
actual case has yet been filed under the Recovery Act; and (ii) the
plaintiffs lack standing due to, among other things, the absence of
any specific injury traceable to PREPA. The Bond Funds and
BlueMountain cross-moved for summary judgment.
The District Court's Ruling
At the outset, the court ruled that the preemption claim was
ripe for review even though neither PREPA nor any other entity had
actually attempted to restructure its obligations under the
Recovery Act. According to the court, the "plaintiffs'
preemption and contract clauses claims rely on the enactment of the
Recovery Act, not on its application." The court explained
that the plaintiffs were seeking a declaration, not that the
Recovery Act would be preempted if enforced in a hypothetical way,
but that it is unconstitutional because federal law preempts it.
The court also concluded that delaying adjudication on the merits
of the plaintiffs' constitutional claims until PREPA invokes
the Recovery Act "would continue to inflict hardship on
plaintiffs" due to Puerto Rico's nullification, by
enacting the Recovery Act, of a series of statutory and contractual
security rights and remedial provisions "with no identifiable
corresponding gain."
The court ruled that "by enacting section 903(1) [of the
Bankruptcy Code], Congress expressly preempted state laws that
prescribe a method of composition of municipal indebtedness that
binds nonconsenting creditors."
Section 903 provides as follows:
This chapter [chapter 9] does not limit or impair the power of a
State to control, by legislation or otherwise, a municipality of or
in such State in the exercise of the political or governmental
powers of such municipality, including expenditures for such
exercise, but–
(1) a State law prescribing a method of composition of
indebtedness of such municipality may not bind any creditor that
does not consent to such composition; and
(2) a judgment entered under such a law may not bind a creditor
that does not consent to such composition.
According to the court: (i) Puerto Rico is a "State"
within the meaning of section 903 because section 101(52) of the
Bankruptcy Code provides that "[t]he term 'State'
includes the District of Columbia and Puerto Rico, except for the
purpose of defining who may be a debtor under
chapter 9 of this title," and section 903 "says nothing
of who may be a Chapter 9 debtor"; (ii) the Recovery Act,
because it establishes procedures for indebted public corporations
to adjust or discharge their obligations to creditors,
"prescribes a method of composition of indebtedness, which is
exactly what section 903(1) prohibits"; (iii) the Recovery Act
applies to the debts of Puerto Rico "instrumentalities,"
which are "municipalities" for purposes of section
903(1); and (iv) because the Recovery Act does not require
unanimous creditor consent, the compositions prescribed in the
Recovery Act may bind nonconsenting creditors, contrary to section
903(1).
The court explained that the legislative history of section 903(1)
bolsters its conclusion that Congress intended to preempt any
Puerto Rico law creating municipal debt restructuring
procedures that purport to bind nonconsenting creditors. It
rejected the defendants' argument that it would be
"anomalous" to read the Bankruptcy Code as both
precluding Puerto Rico municipalities from filing for chapter 9
protection and preempting Puerto Rico laws that govern debt
restructuring for Puerto Rico municipalities. The court wrote that
Congress's decision not to permit Puerto Rico municipalities to
be chapter 9 debtors (under section 101(52), which, as noted,
excludes Puerto Rico from the definition of "State" for
purposes of chapter 9 eligibility), "reflects its considered
judgment to retain control over any restructuring of municipal debt
in Puerto Rico."
The court also rejected the defendants' contention that
section 903 does not apply to Puerto Rico because Puerto Rico
municipalities are not eligible to be debtors under chapter 9.
According to the court, "[n]othing in the text, context, or
legislative history of section 903 remotely supports the
Commonwealth defendants' inferential leap that Congress
intended the prohibition in section 903(1) to apply only to states
whose municipalities are eligible to file for Chapter 9
bankruptcy."
Finally, the court was not persuaded by the defendants'
argument that section 903 "by its terms is limited to the
relationship between an 'indebted[]' municipality and its
'creditors' in Chapter 9 cases" and that
"[u]nless a municipality can qualify as a 'debtor'
under Chapter 9, it obviously cannot be an 'indebted[]'
municipality with a 'creditor' under Chapter 9." This
"strained reading" based on the definition of
"creditor" in section 101(10) of the Bankruptcy Code must
fail, the court wrote, because "nothing in that definition
indicates that the term 'creditor' is limited to entities
eligible to bring claims pursuant to Chapter 9."
The court acknowledged that federal preemption of a state law
"is strong medicine" and that preemption "will not
lie absent evidence of clear and manifest congressional
purpose" (citation omitted). However, the court wrote,
"[d]espite this high bar, this is not a close case." It
accordingly ruled that "[t]he Commonwealth defendants, and
their successors in office, are permanently enjoined from enforcing
the Recovery Act."
Outlook
If upheld on appeal, the ramifications of BlueMountain Capital
Management may extend beyond the fate of PREPA, Puerto Rico's
other public corporations, and their collective $20 billion in bond
debt. The Recovery Act was designed to insulate the Puerto Rico
fisc and its far greater general obligation bond debt from the
financial troubles of the commonwealth's instrumentalities.
Moreover, without the threat of recourse to the Recovery Act as a
means of bringing PREPA and other public corporation creditors to
the table for meaningful restructuring negotiations, creditors may
simply walk away from the process.
On February 19, 2015, the defendants urged the U.S. Court of
Appeals for the First Circuit to issue an expedited ruling on the
appeal. According to the defendants, the Recovery Act represented
an "emergency response to the most profound fiscal crisis in
Commonwealth history." They also stated that unilateral action
by creditors, such as accelerating debt repayments from PREPA,
suing to raise electricity rates, or seeking to appoint a receiver,
would "disrupt the provision of essential public services in
Puerto Rico."
Given the consequences for Puerto Rico, the ruling could spur
Congress to act. Among other things, lawmakers could amend the
Bankruptcy Code to permit Puerto Rico's public corporations to
file for chapter 9 protection. Resident Commissioner Pedro
Pierluisi, the Commonwealth of Puerto Rico's representative in
Congress, reintroduced a bill on February 11, 2015 (the Puerto Rico
Chapter 9 Uniformity Act of 2015 (H.R. 870)) that would allow
Puerto Rico's public agencies to be debtors under chapter 9.
The bill is nearly identical to one Pierluisi introduced in 2014.
The House Judiciary Subcommittee on Regulatory Reform, Commercial
and Antitrust Law held a hearing on February 26, 2015, to examine
H.R. 870. A summary of the testimony given at the hearing is
available here.
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