alerts & publications

First Circuit Affirms Unconstitutionality of Puerto Rico’s Recovery Act: First of Several Legal Roadblocks Ahead for Puerto Rico

Puerto Rico encountered another roadblock in its efforts to resolve its looming debt crisis on July 6, 2015, when the U.S. Court of Appeals for the First Circuit affirmed the decision of the District of Puerto Rico that Puerto Rico’s Debt Enforcement and Recovery Act (the “Recovery Act”) is unconstitutional and permanently enjoined its enforcement.¹ The Recovery Act, enacted in June 2014, created a bankruptcy-like regime through which select Puerto Rican public corporations could restructure their debt obligations without unanimous creditor consent. Like the district court, the First Circuit concluded that the Recovery Act was preempted in its entirety by Section 903(1) of the U.S. Bankruptcy Code, which prohibits “States” (including Puerto Rico) from enacting laws that bind non-consenting creditors to the terms of a debt restructuring. Unlike the district court, the First Circuit did not address whether the law violated the Constitution’s Contract Clause.

The First Circuit decision was handed down not long after the much anticipated Krueger report—a white paper commissioned by Puerto Rico’s administration that addresses Puerto Rico’s financial situation—indicated that Puerto Rico’s financial condition was worse than previously believed and is unlikely to be cured without a debt restructuring. In light of this report, and concurrently with Puerto Rico’s appeal to the Supreme Court, Puerto Rico is redoubling its efforts to obtain congressional support for an extension of chapter 9 of the Bankruptcy Code. Even if Puerto Rico secures chapter 9 protection, however, a chapter 9 filing will not be a panacea for its debt crisis as the island’s constitutionally protected government obligation (“GO”) bonds would not be addressed and obligations of the deeply troubled Government Development Bank (the “GDB”) would possibly fall outside chapter 9’s purview.

As Puerto Rico presses its Recovery Act and pursues chapter 9, the Constitution’s Contract Clause continues to loom as a potential legal barrier to any less-than-consensual restructuring. While the First Circuit skirted a Contract Clause analysis, the district court’s decision regarding the Recovery Act was a clear win for bondholders on Contract Clause grounds. Whether recent efforts by Puerto Rico or the Krueger report will tip the balance toward Puerto Rico may be the next legal battle in this ongoing situation.

The First Circuit’s Decision

Though significant, this decision was not particularly surprising to those closely following the Puerto Rico debt crisis. Indeed, when the constitutionality of the Recovery Act was first challenged by bondholders of Puerto Rico Electric Power Authority—one of the public corporations the Recovery Act sought to protect—O’Melveny issued a client alert analyzing the serious preemption and other constitutional issues presented by the Recovery Act.

The primary issue before the First Circuit was whether Section 903(1) of the Bankruptcy Code preempts Puerto Rico from enacting its own municipal bankruptcy law. Section 903(1) expressly prohibits “states” from enacting their own laws. The question here then turned on whether Puerto Rico is a state under the Bankruptcy Code. “State” is generally defined to include Puerto Rico, “except” for the purpose of “defining” a municipal debtor under Section 109(c) of the Bankruptcy Code.² Based on the plain language of these provisions, the majority of the First Circuit panel concluded that Section 903(1) does apply to Puerto Rico and, as a result, precludes passage of laws like the Recovery Act.

Looking Ahead: Is Chapter 9 a Solution?

The First Circuit’s decision identified Congress as the proper governmental arm to address Puerto Rico’s debt crisis. In denying Puerto Rico the power to file for chapter 9 relief, which would enable Puerto Rico’s municipalities³ to file for bankruptcy, the First Circuit found that Congress retained the authority to decide which solution is best for Puerto Rico. According to the court, the solutions available to Congress may in fact be broader and more flexible than initially perceived (i.e., simply granting Puerto Rico’s municipalities access to chapter 9). By virtue of Puerto Rico’s classification as a “territory,” the First Circuit concluded that Puerto Rico has a different constitutional status than that of states, meaning that the typical constraints imposed by the Tenth Amendment on Congress’s ability to address municipal insolvency in the states do not apply to Puerto Rico. As a result, the Court declared that “Congress may wish to adopt other—and possibly better—options to address the insolvency of Puerto Rico municipalities that are not available to it when addressing similar problems in the states.”⁴

The First Circuit decision thus puts mounting pressure on Congress to act. The only tactic Congress has considered thus far is expanding chapter 9’s protections to Puerto Rico. Prior to the court’s decision, congressional legislation that would allow Puerto Rico’s municipalities to commence proceedings under chapter 9 was pending, introduced by Resident Commissioner of Puerto Rico, Representative Pedro R. Pierluisi, in February 2015.⁵ However, House Judiciary Committee leaders have not shown support for the proposed law, arguing that chapter 9 will not, on its own, resolve Puerto Rico’s financial crisis and instead are calling for a more holistic congressional response.⁶ Still, several Democratic-party leaders, including Hillary Clinton, have ramped up pressure on Congress to reopen chapter 9 to Puerto Rico’s municipalities, especially following the release of the Krueger report.

What is left out of this political debate is the two tranches of debt that will not necessarily be addressed by chapter 9—the constitutionally guaranteed GO-bond debt and the GDB debt. As noted above, the GO-bond debt is outside the purview of chapter 9 because that debt belongs to Puerto Rico, not one of its municipalities. The GDB debt may also fall outside bankruptcy laws, since it is uncertain whether chapter 9 could even reach the GDB. While the Bankruptcy Code explicitly prohibits banks from seeking chapter 7 or chapter 11 relief, there is no such express prohibition in chapter 9. However, if a court finds the GDB to be a bank and also that it would thwart the purpose of the statute to permit a bank to file for bankruptcy protection, the plain reading of the statute could be challenged. Thus, whether the GDB is eligible to file under chapter 9, if such protection is even extended to the Commonwealth and its municipalities, will become a matter of statutory interpretation, unless it is expressly addressed by the enacting statute.

Contract Clause Implications

If Puerto Rico is unable to obtain eligibility for chapter 9—and to some extent, even if it is—Puerto Rico will continue to face constitutional challenges to its actions. One lesson learned through the district court’s analysis of the Recovery Act challenge is that if the Commonwealth’s solution is dependent on the enactment of some statutory measure, one issue that will be at the forefront is whether that path is consistent with the U.S. Constitution’s Contract Clause. Though the First Circuit found it unnecessary to reach the Contracts Clause issue, the district court held that the claim that the Recovery Act violates the Contracts Clause was at least plausible enough to survive a motion to dismiss. The district court’s analysis informs how a court may approach other measures the Commonwealth may pursue (e.g., a temporary moratorium on public debt, as discussed below). But the real question is whether, as Puerto Rico has asserted, its recent actions and the Krueger Report shift that analysis.

If the Contracts Clause is at issue in future litigation, creditors will need to show (1) that the law effects a “substantial impairment” of a contractual relationship and (2) that it was not “reasonable and necessary to serve an important government purpose”⁷ to prove a violation. Satisfying the first prong is a foregone conclusion, since any meaningful action Puerto Rico would take at this stage would amount to a substantial impairment to the creditors’ rights under the contracts. Therefore, the crux will be whether these steps are “reasonable and necessary to serve an important government purpose.” The key factors to this analysis are whether the ordinance (1) was an emergency measure; (2) was one to protect a basic societal interest, rather than particular individuals; (3) was tailored appropriately to its purpose; (4) imposed reasonable conditions; and (5) was limited to the duration of the emergency.⁸

In connection with the First Circuit appeal, Puerto Rico took the position that the Krueger Report affirmed that the Commonwealth lacks the legislative tools necessary for restructuring its public debt burden, which is driven, at least in part, by its public enterprises. The report noted that supply-side factors, such as its low employment rate, severely impact the Commonwealth’s financial state. While the report directs Puerto Rico to a comprehensive approach, it suggests that a debt restructuring is a key element for a resolution.

One measure that Governor Padilla has proposed in an effort to stave off a fiscal crisis is a multi-year repayment moratorium, although he has not yet provided specifics on such a plan. Though such a measure, at first blush, may seem to meet the necessary prong of “reasonable and necessary,” the same could arguably have been said regarding the Recovery Act. Yet, with the Recovery Act, the district court expressed skepticism of the necessity of measures that seek to avoid debt obligation as opposed to looking, instead, to revenue-raising reforms such as spending cuts and tax reform. Whether the Krueger report’s implicit assumption that a debt restructuring is required would affect this analysis is unclear. But imposing a moratorium on repayment out of the gate could be viewed as a rash reaction, especially if enacted prior to exploring less extreme measures, particularly from among the myriad reforms proposed by the Krueger report.

Paths to Recovery and the Role of the Government Development Bank

For now, the Commonwealth is endeavoring to avoid litigation and to attempt a consensual restructuring. Following the first meeting of the governor’s working group, GDB president Melba Acosta said that the government looks to negotiate payment terms and propose the GDB notes exchange, not seek cuts to principal or similar measures as was originally feared. In the weeks, months, and years ahead, the GDB and GDB bonds will be central to initial restructuring efforts and will likely be the bellwether for future restructuring efforts. In the first meeting with the bondholder group, on July 13, Acosta noted that she expects all parties, from creditors to government employees, to shoulder the burden, while noting that the Commonwealth is not seeking a bailout from the federal government. Nevertheless, with the number of debt issuers, their various rights, and the holdout problem present in any restructuring, it is likely that Puerto Rico will again find itself litigating key constitutional issues.

[1] Franklin Cal. Tax-Free Trust v. Puerto Rico, Case Nos. 15-1218, 15-1221, 15-1271, 15-1272, slip. op. at 4 (1st Cir. July 6, 2015).

[2] 11 U.S.C. § 101(52).

[3] Section 101(40) of the Bankruptcy Code defines “municipality” as a “political subdivision or public agency or instrumentality of the state.” 11 U.S.C.§ 101(40).

[4] Franklin, slip op. at 31.

[5] See Puerto Rico Chapter 9 Uniformity Act of 2015, H.R. 870, 114th Cong. (2015-2016).

[6] Press Release, Goodlatte and Marino Statement on Recent Developments Regarding Puerto Rico (July 8, 2015), http://www.judiciary.house.gov/index.cfm/2015/7/goodlatte-and-marino-statement-on-recent-developments-regarding-puerto-rico.

[7] U.S. Trust Co. v. New Jersey, 431 U.S. 1, 25 (1977).

[8] Allied Structural Steel Co. v. Spannaus, 438 U.S. 234, 243 (1978).