On August 11, Franklin Funds and Oppenheimer Rochester Funds filed a second amended complaint, opposition to motion to dismiss and cross-motion for summary judgment in the litigation they previously filed in the United States District Court for Puerto Rico challenging the constitutionality and validity of Puerto Rico's so-called Recovery Act. The second amended complaint reiterates that a PREPA filing under the Recovery Act, which establishes debt adjustment procedures for most of Puerto Rico's public corporations, is both "probable and imminent." The motion seeks summary judgment on two of the plaintiffs' claims: that the Recovery Act is constitutionally and statutorily preempted, and that the Recovery Act's automatic stay provisions are illegal to the extent they purport to preclude a federal court action. The motion asserts that these two claims are "purely legal, and will not be clarified by further factual development."
The summary judgment motion re-enforces our prior assessment that, once the court is persuaded to address the merits, one of the plaintiffs' strongest arguments is that Section 903 of the federal Bankruptcy Code precludes enforcement of any Recovery Act debt adjustment against non-consenting bondholders.
The motion, referencing legislative history and prior case law, effectively dispenses with Puerto Rico's relatively weak arguments that Section 903 cannot or should not be read as applicable to Puerto Rico's public corporations. Puerto Rico has argued that Congress could not have intended to leave its public instrumentalities without access to any debt adjustment process, which, given Puerto Rico's express exclusion from eligibility under Chapter 9 of the Bankruptcy Code, would be the effect of applying Section 903 to Puerto Rico's own public corporation insolvency legislation. Whether Congress indeed intended to leave Puerto Rico in such a predicament is unclear. The plaintiff's brief suggests that because Puerto Rico's bonds, unlike any state's bonds, benefit from nationwide triple tax-exemption (which accounts for Puerto Rico's status as the third highest volume issuer of tax-exempt bonds after California and New York), "Congress did not want Puerto Rico to restructure its municipal debt through either its own laws or Chapter 9." Whether this or any other rationale for Puerto Rico's statutory treatment under the Bankruptcy Code exists, the plaintiffs' motion argues that the statutory language in Chapter 9 is explicit, and that if Puerto Rico is unhappy with its position, "Puerto Rico's remedy lies ... with Congress."
Although Section 903 does not technically preempt or prohibit all of the Recovery Act, if a court agrees that Section 903 is applicable, any debt adjustment produced by the Recovery Act's procedures could not be enforced against non-consenting creditors, thereby rendering the Recovery Act largely ineffective as a debt adjustment mechanism.
For an adjudication of the plaintiffs' challenge to take place in federal court, plaintiffs must establish standing and ripeness. The Commonwealth and PREPA have asserted the obvious argument that PREPA has not filed under the Recovery Act, and that therefore there is no case or controversy to adjudicate. The plaintiffs' summary judgment motion, like the original complaint, argues that the plaintiff PREPA bondholders have suffered a devaluation of their bonds as a result of the Recovery Act's enactment, and that they are forced to litigate before a filing because the automatic stay provisions of the Recovery Act would preclude them from pursuing federal court litigation after a PREPA filing under the Recovery Act. (As noted, the plaintiffs simultaneously seek summary judgment on the unconstitutionality of any such application of the Recovery Act's automatic stay to preclude or freeze a federal court action.) Whether these arguments that the case is ripe for adjudication will find traction with the court remains to be seen.
The filing also previews arguments that will be further litigated if the Recovery Act survives the plaintiffs' preemption claim. The plaintiffs assert that the Recovery Act's provisions effect an unconstitutional impairment of contracts. As we have previously discussed, courts have interpreted the "Contracts clause" not as an absolute bar to impairment of contracts by state action, but rather as a balancing test in which the state's interests and needs and the extent of the contractual impairment are weighed against each other. This makes contract impairment claims highly fact-sensitive and unlikely candidates for summary judgment. For example, the plaintiffs' brief argues that PREPA has the following alternatives to impairing its bonds through debt adjustment:
(1) PREPA can raise rates.
(2) The Commonwealth of Puerto Rico could repay over $640,000,000 it owes to PREPA.
(3) The Commonwealth could reduce PREPA's taxes and subsidies which the brief asserts amount to over $1 billion from 2014 through 2018.
(4) PREPA should collect its full accounts receivable and pay subsidies after debt service instead of permitting customers to offset subsidies from their payments.
(5) PREPA should cut costs and address inefficiencies.
(6) PREPA should strengthen its capital markets reputation by hiring an investment banker and making public presentations.
If PREPA, or any other public corporation, eventually seeks protection and debt adjustment under the Recovery Act, these types of arguments about whether the applicable issuer requires any debt adjustment in order to maintain financial and operational viability (and, if so, whether the proposed amount of debt adjustment is necessary for such viability) will be front and center in such proceedings.
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