Puerto Rico Restructuring Law to Face Constitutional Challenges

July 3, 2014


Background—Fiscal Crisis in Puerto Rico

Puerto Rico is facing an impending fiscal crisis, brought on by the island’s US$73 billion in municipal debt. While the government is actively implementing reforms and engaging in tax hikes to address its overwhelming debt, such efforts are not likely to be sufficient, and with the upcoming maturity of Puerto Rico Electric Power Authority’s (PREPA) bank credit lines in August, there is a very real possibility that the entity will default on its debt. The prospect of default has drawn the attention (and anxiety) of both investors and legal analysts, because until last week, Puerto Rico did not have any legal regime for its municipal entities' bankruptcy.

Due to the construction of Chapters 11 and 9 of the US Bankruptcy Code, Puerto Rico is denied federal bankruptcy law protections. Chapter 11 excludes all municipalities and Chapter 9 specifically excludes Puerto Rico from eligibility. In an attempt to protect key government entities in the face of a potential imminent default, last week, Puerto Rico passed the “Puerto Rico Public Corporation Debt Enforcement and Recovery Act” (the “Act”), which gives three of the island’s most important municipal entities avenues for restructuring their debt. The future of the law, however, is in question, as investors have already brought a lawsuit challenging its constitutionality. The new legislation provides both comfort and consternation for investors, raises novel issues of bankruptcy law, and will have significant implications for Puerto Rico’s municipal debt and the $3.7 trillion municipal bond market in general.

Summary—The Puerto Rico Public Corporation Debt Enforcement and Recovery Act

The 134-page law was proposed by Governor García Padilla on Wednesday, June 25, and quickly passed both houses of the Puerto Rico Assembly and was signed three days later. The law is set to expire at the end of 2016 and would provide at least temporary structure to any future default by certain of the island's public corporations.

The Act authorizes two paths for restructuring that may be pursued sequentially or simultaneously, and is expressly based on key provisions from Chapter 11 of the federal Bankruptcy Code. The first path—Chapter 2—is intended to provide a consensual negotiated restructuring. The process begins with the entity designating the particular debt instruments it intends to restructure, or the “affected debt.” The process includes a nine-month suspension period during which creditors are prevented from exercising remedies under their contracts. During this time, the corporation and creditors negotiate amendments to or exchanges of the affected debt and a recovery program for the entity. In order for the amendments to be approved, more than 50 percent of the holders of the affected debt must participate in the vote and 75 percent of those voting must approve the amendments. Finally, a Puerto Rico judge must approve the plan, after which a three-person oversight committee begins monitoring the implementation. A proposed plan must ultimately enable the entity to become financially self-sufficient, equally allocate the burdens of recovery among all stakeholders and treat all creditors within the same class equally. If the plan is not approved within the nine-month window, the corporation moves automatically onto the second path.

This second path is akin to a bankruptcy “cramdown” and appears to be structured to encourage a consensual deal through Chapter 2 of the Act while providing some certainty of resolution. Under Chapter 3 of the Act, a public corporation petitions a Puerto Rico court to initiate the process and, as with Chapter 9 of the Bankruptcy Code, insolvency of the entity must be established. An automatic stay arises upon the filing of the petition, preventing creditors from exercising remedies under their contracts. Only the entity or the Government Development Bank can propose a plan, which must provide to each creditor what it would have received if all creditors had demanded immediate payment at the time of the petition. In addition, if the entity has positive free cash flow, 50 percent of that must be directed toward paying creditors their pro rata shares for ten years commencing from the plan's effective date. Certain classes and claims are expressly protected from impairment—in particular, claims relating to employment benefits. Final approval of the plan only requires the consent of a single class of creditors, and a special court created by the Act oversees compliance with the plan.

Challenges—What Should Our Clients Expect Next?

The uncertainty surrounding the legislation springs almost entirely from the unique and vague status of the Commonwealth of Puerto Rico as an unincorporated territory, which raises several potential constitutional and statutory challenges.

Preemption by the Federal Government

The Supremacy Clause of the United States Constitution provides for the preemption of state laws that conflict with federal laws. Here, there is a valid question as to whether the federal Bankruptcy Code preempts the Act.

Article 1, section 8, clause 4 of the United States Constitution reserves the power to legislate in the area of bankruptcy to the federal government. This has been construed to prohibit states from enacting bankruptcy laws, i.e. state laws that offer debtors a discharge of their debts. Because the Act’s purpose is to compromise creditor claims without consent in order for the petitioning entity to be rehabilitated, the Act appears to trespass on the field occupied by federal bankruptcy legislation.

In addition, the language of the bankruptcy code itself—specifically, Section 101(52)—suggests that Congress intended to exclude Puerto Rico from accessing any bankruptcy process, giving rise to implied preemption by conflict. Section 101(52) provides that the term “State” includes Puerto Rico with the exception of eligibility to be a debtor, effectively eliminating the ability of Puerto Rico’s municipalities to seek relief under the Bankruptcy Code. By expressly considering and excluding Puerto Rico’s municipalities from eligibility for bankruptcy, Congress arguably intended to preclude Puerto Rico from any bankruptcy process, and the Act interferes with that purpose.

The drafters of Puerto Rico’s new legislation counter this argument by insisting that the gap in access to Chapter 9 coverage was unintended. Language in the new law further attempts to skirt the preemption issue by providing, “this is not a bankruptcy act, but an orderly debt enforcement act.” Moreover, the drafters recite a 1942 United States Supreme Court case involving Asbury Park, New Jersey, for the proposition that states may enact insolvency laws under their police power for entities ineligible for relief under federal laws.1 There, the Supreme Court affirmed a decision to uphold a New Jersey state insolvency statute enacted after a federal municipal bankruptcy statute was struck down and before the enactment of a federal law successor. In its decision, the Supreme Court held that the New Jersey statute was not preempted given the gap in time between the federal statutory schemes. Its applicability to the Act is questionable, however, in light of Chapter 9 of the Bankruptcy Code. It will be up to the courts to determine if the Act in fact encroaches on Congress’ prerogative with regard to bankruptcy legislation.

Prohibition by Plain Reading of Section 903 of the Bankruptcy Code

A similar preclusion argument can be made from a plain reading of Section 903 of the Bankruptcy Code, which appears to expressly prevent Puerto Rico from enacting legislation that mirrors the powers of bankruptcy law. The law reads:

                    This chapter 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 . . . .

Because Section 101(52) defines “State” to include Puerto Rico (other than for eligibility), it can be argued that Section 903’s proscription of state laws that bind non-consenting creditors directly conflicts with the intention and effect of the Act. Indeed, the language in Section 101(52) does not say that Puerto Rico is a state “except for the purposes of Chapter 9” or similarly broad language, but is instead limited to defining who may be a debtor under Section 109(c) of the Bankruptcy Code. Further, Section 903’s proscription against state bankruptcy laws on its face applies to all states, not only those that are eligible to be debtors under Chapter 9. If the statute applies to Puerto Rico, the Act unquestionably runs afoul of Section 903’s limitations by allowing objecting creditors’ claims to be impaired by a class vote or through a “cramdown”-like process.

Violation of the Contracts Clause

Finally, under the Contracts Clause of the United States Constitution2, as well as the Constitution of Puerto Rico, the government of Puerto Rico may not impair contract rights unless necessary to serve an important public interest. This exception is narrower when a state is one of the contracting parties because of the risk that the state will abuse the exception to its favor and undermine confidence in public contracts. In 2011, the First Circuit ruled on a contract impairment case stemming from a law passed in Puerto Rico aimed at cutting the island’s structural deficit by reducing government payroll. The court analyzed the claim that altering employees’ contracts violated the Contracts Clause based on “whether the impairment was reasonable and necessary to effectuate an important governmental purpose.” The court reaffirmed that in contracts where the state itself is a party, a higher level of scrutiny applies and then laid out the factors that should be considered. These include whether the law: (1) was an emergency measure; (2) protected a basic societal interest, rather than the interests of particular individuals; (3) was tailored appropriately to its purpose; (4) imposed reasonable conditions; and (5) was limited to the duration of the emergency. The question at issue is whether the Act fits within this narrow exception to the Contracts Clause.

Courts may find that the intractable fiscal woes facing Puerto Rico’s public corporations create the required necessity. There is a strong argument for government exercise of its police power to meet the basic needs of its citizens; here—power, water, sewers and transport. The new law is aimed at advancing the fiscal solvency of these essential public corporations and arguably fits within the narrow judicial understanding of “necessity” in this instance. However, whether the new legislation is “reasonable” seems far less clear. The drafters of the Act rely on the Asbury Park case to support the constitutionality of the statute. While Chapter 2 of the Act facially fits within the parameters of the New Jersey statute that the court upheld, the viability of Asbury Park and its application here are less certain. Ultimately, this determination will hinge on a broader analysis of the options available to Puerto Rico, its public corporations, and their creditors.

In sum, the situation in Puerto Rico is reaching a critical point and will remain fluid over the coming weeks and months. All eyes will be on PREPA, its ability to make payments coming due in August and whether it will be taking advantage of the Act before then. Because the island’s bonds are widely held by institutional investors, such as retirement and mutual funds, which are drawn to their tax-free status, the ripple effect of this new law and the legal challenges to its constitutionality will be felt across the mainland and in the troubled waters of Puerto Rico debt restructuring.


1 Faitoute Iron & Steel Co. v. City of Asbury Park, 316 U.S. 502 (1942).
2 Although Puerto Rico is not a “state,” courts considering the matter have held that Puerto Rico is still bound by the Contracts Clause.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Suzzanne Uhland, an O'Melveny partner licensed to practice law in California and the District of Columbia, Jennifer Taylor, an O'Melveny counsel licensed to practice law in California, Martha Todd, an O'Melveny associate licensed to practice law in California, and Jake Leraul, a law clerk supervised by principals of the firm, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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