Legal Fault Lines Over Puerto Rico Restructuring Law Come Into Focus

In my estimation, and from talking to our clients, Reorg Research is providing the very best, most informed news, analysis, and commentary on the hottest topic in distressed: Puerto Rico. As I've told many people recently, this is a situation that we will be talking about for many years to come.

Last week, a few members of our team wrote a piece laying down some of the legal issues inherent in the some of the various litigations coming out of the U.S. District Court for the District of Puerto Rico. For more information on Reorg Research or to inquire about a subscription, please shoot us an email questions [at] reorg-research [dot] com. Enjoy!

Legal Fault Lines Over Puerto Rico Restructuring Law Come Into Focus

The battle against Puerto Rico's independent restructuring efforts is becoming more clear as a third opponent, BlueMountain, joined Franklin Templeton and Oppenheimer in litigation challenging the recently enacted Public Corporation Debt Enforcement and Recovery Act. With BlueMountain's complaint, funds managing more than $2.1 billion of the $8.6 billion PREPA bonds outstanding, the litigating parties represent a heavy percentage of PREPA bondholders actively opposed to the Recovery Act.

When viewed together, the complaints provide a clear picture both of what is at stake and what challenges the Recovery Act will face. The theme of the opposition is that the Recovery Act violates both the U.S. Constitution and the Puerto Rico Constitution as well as federal law. While both complaints seek to invalidate the law, BlueMountain also requests injunctive relief against any attempts by Puerto Rico or its publicly owned corporations to enforce or implement the Recovery Act.

The recently filed motions to dismiss filed by the Commonwealth of Puerto Rico and the Puerto Rico Electric Power Authority, or PREPA, also display the legal roadmap for efforts to defend the Recovery Act. PREPA and Puerto Rico stress that the Recovery Act is a valid exercise of the legislature, as evidenced by language introducing the legislation, which provides that the Recovery Act "is not a bankruptcy act, but an orderly debt enforcement act for the eligible public corporations."

Anti-Injunction Act

At least one thing appears certain: The litigation will not be resolved overnight. An initiation of procedures in the Puerto Rican courts under the new restructuring law by PREPA or any other eligible Puerto Rico publicly owned corporation could complicate things even more and push out any timeline for a resolution of the litigation because the ability of the U.S. District Court for the District of Puerto Rico to enjoin a proceeding under Puerto Rican law may be slowed by the Anti-Injunction Act (28 U.S.C. § 2283), which provides that "[a] court of the United States may not grant an injunction to stay proceedings in a State court except as expressly authorized by Act of Congress, or where necessary in aid of its jurisdiction, or to protect or effectuate its judgment." The applicability of this law to the unique situation of Puerto Rico's new restructuring law is uncertain, and fighting over the issue will likely take some time. If the Anti-Injunction Act applies, a Puerto Rican court process could conceivably continue in the face of legal challenges. That being said, the U.S. constitutional issues raised by Franklin, Oppenheimer and BlueMountain will likely be raised in the Puerto Rican proceedings, particularly at the eligibility hearing proscribed by section 306 of the Recovery Act.

Preemption and Conflicts with the Bankruptcy Code

The Bankruptcy Code of the U.S. Constitution provides that "[t]he Congress shall have Power To...establish...uniform Laws on the subject of Bankruptcies throughout the United States. . . ." Here, the parties disagree over whether the Bankruptcy Clause and/or conflicts between the Bankruptcy Code and the Recovery Act invalidate the newly enacted legislation based on preemption.

The parties do not dispute that the Bankruptcy Code expressly excludes Puerto Rico from eligibility under Chapter 9. However, what is less clear and the focal point of debate between the parties is whether the Bankruptcy Clause preempts Puerto Rico from creating its own restructuring laws and also whether those laws include impermissible conflicts with the Bankruptcy Code.

Puerto Rico and PREPA dispute the preemption arguments, citing to the 1942 Supreme Court case Faitoute Iron & Steel Co. v. City of Asbury Park, N.J., in which the court concluded that a state's police power justified New Jersey's enactment of its own public debt enforcement and adjustment statute. They cite Asbury for the argument that "state and local governments retain the power to pass their own restructuring statutes, so long as they do not conflict with federal law." Puerto Rico argues that the principals of Asbury Park comports with the "sovereign police power" set forth in the Puerto Rico Constitution, providing that "[t]he power of the Legislative Assembly to enact laws for the protection of the life, health and general welfare of the  people shall . . . not be construed restrictively."

Puerto Rico's also argues that its public entities "are not currently governed by any federal bankruptcy law," similar to banks and insurance companies who are expressly excluded from the Bankruptcy Code's eligibility provisions set forth in section 109(b). In this case, Puerto Rico argues that while Congress enacted federal bankruptcy law in the form of the Bankruptcy Code, Puerto Rico is excluded as a debtor from the Bankruptcy Code and its publicly owned business entities are "governmental units" ineligible to seek relief under chapter 11. Based on these exclusions, Puerto Rico argues that the Recovery Act is an appropriate exercise of its police power because it is effectively filling the gap created by the Bankruptcy Code.

In rejecting Puerto Rico's arguments that the Recovery Act does not conflict with the Bankruptcy Code, the plaintiffs cite to section 903(1) of the Bankruptcy Code, which was enacted following the decision in Asbury Park and precludes a state from binding a creditor to an adjustment or discharge of obligations without the creditor's consent. The complaints note that while Puerto Rico is excluded from the meaning of "State" for eligibility purposes, it is not excluded for purposes of other Bankruptcy Code provisions such as section 903(1). They say that the Recovery Act provides for binding adjustments without creditor consent, in clear contravention of section 903(1).

Puerto Rico, however, responds that "[s]ection 903 can and should be read to permit Puerto Rico to enact restructuring legislation that complements-and in no way conflicts with-its federal counterpart." In support of its argument, Puerto Rico argues that "because Puerto Rico's public corporations may not avail themselves of Chapter 9, Section 903-which, by its own terms, applies only when Chapter 9 is invoked-is wholly inapplicable to the Commonwealth." Puerto Rico's motion to dismiss goes on to characterize the plaintiff's reading of section 903 and the related definition of a "State" under section 101(52) as "absurd" because such an interpretation would deprive Puerto Rico of its ability to exercise its "traditional police power" and preempt Puerto Rico from enacting the restructuring legislation necessary to help it escape the "financial ruin" in which it finds itself.

Beyond preemption based on the alleged conflict between the Recovery Act and section 903 of the Bankruptcy Code, BlueMountain cites to the Supreme Court's 1929 decision in Int'l Shoe Co. v. Pinkus, which provides that "[s]tates may not pass or enforce laws to interfere with or complement the Bankruptcy Act or to provide additional or auxiliary regulations." The Recovery Act, BlueMountain argues, "is preempted because it improperly operates in a field that Congress has comprehensively occupied." Further, BlueMountain asserts that even if Congress has not completely preempted state regulation of bankruptcy, "the Act would still be preempted because its bankruptcy-like provisions would stand as an obstacle to accomplishing and executing Congress's purposes and objectives in enacting a uniform bankruptcy code."

At some level, this last argument presupposes that Congress' objective was to exclude Puerto Rican-owned entities from bankruptcy protection. Defenders of the new law imply, however, that PREPA and other island-owned companies fall into a "hole" in the Bankruptcy Code.

Contract Clause

The Contract Clause of the United States Constitution provides that "No State shall . . . pass any . . . Law impairing the Obligation of Contracts." The complaints of BlueMountain, Franklin and Oppenheimer argue that the Recovery Act "substantially impairs" the obligations contained in the PREPA bonds, most notably because it deprives the bondholders "of their contractual rights to payment in full of their claims." The parties challenge the Recovery Act as law that provides an impermissible discharge of a contractual obligation. In support of their arguments, the plaintiffs cite to the 1819 Supreme Court decision from Sturges v. Crowninshield, which held that New York law "so far as it attempts to discharge the contract on which this suit was instituted, is a law impairing the obligation of contracts within the meaning of the constitution of the United States."

Responding to the Contract Clause challenges, PREPA and Puerto Rico point out that "[t]he Contract Clause's prohibition on the enactment of laws impairing contractual obligations 'is not an absolute one' and 'does not make unlawful every state law that conflicts with any contract.'" Beyond the initial inquiry of impairment, Puerto Rico stress that any Contract Clause inquiry must go beyond impairment and must demonstrate that the Recovery Act is not "reasonable and necessary to the achievement of a sufficiently important government interest so as to render them constitutional exercises of the state's police power." Puerto Rico cites to the motives set forth in the Recovery Act, most notably the most-severe "fiscal emergency" in the Commonwealth's history as adequate support for the contractual impairment provisions of the Recovery Act.

Similarly, in the case of Asbury Park, the Supreme Court cited to Sturges, which provided that "a state insolvency act is limited by the Contract Clause of the Constitution in authorizing composition of pre-existing debts," but the Court also pointed out that any Contract Clause analysis "depends on what is affected by such a composition, and what state power it brings into play." The Supreme Court in Asbury Park applied a practical approach in addressing whether the Contract Clause "bars the only proven way for assuring payment of unsecured municipal obligations," discounting the contract impairment argument where "a most depreciated claim of little value has, by the very scheme complained of, been saved and transmuted into substantial value."

The Asbury Park decision implies that the Contract Clause is somewhat malleable and will yield to legislation up to a certain point. The question now is whether the Recovery Act has reached or exceeded that point for purposes of a Contract Clause challenge.

Takings Clause

The Franklin/Oppenheimer complaint also argues that the Recovery Act violates the Takings Clause of the Fifth Amendment and Fourteenth Amendments to the U.S. Constitution. The concept of adequate protection is a cornerstone of the Bankruptcy Code that provides "just compensation" upon the granting of a superior lien or a diminishment in a party's property, thereby giving effect to the Takings Clause. In response, Puerto Rico notes that the Recovery Act does not violate the Takings Clause, instead arguing that the legislation affecting creditors' property rights is within its authority as a sovereign. The motion to dismiss also points out that "the Act-like the Bankruptcy Code-satisfies the Fifth Amendment requirements of the U.S. Constitution by providing adequate protection for security interests."

Although the Recovery Act provides a definition of adequate protection that parallels the Bankruptcy Code, it also provides instances where adequate protection is discretionary, not mandatory, raising significant Takings Clause concerns. Most notably, subsection (d) of section 129 of the Recovery Act, which defines adequate protection, provides that:

"Notwithstanding any section of this Act conditioning the eligible obligor's or the petitioner's use or transfer of its property on adequate protection of an entity's interest in the property, if and when the police power justifies and authorizes the temporary or permanent use or transfer of property without adequate protection, the Court may approve such use or transfer without adequate protection."
Similar exceptions found in chapters 2 and 3 of the Recovery Act allow the debtor to forego adequate protection payments "to the extent that sufficient revenues are unavailable for  payment of such principal, interest or other amounts after full payment of such current expenses or operating expenses." This justification based on "police power" and public necessity would seem to go squarely against the Supreme Court's 1935 decision in Louisville Joint Stock Land Bank v. Radford, in which it concluded "[f]or the Fifth Amendment commands that, however great the Nation's need, private property shall not be thus taken even for a wholly public use without just compensation."

Stay of Federal Litigation

One of the more interesting arguments presented by both complaints is the permissibility of the Recovery Act's automatic stay on proceedings in federal courts.  With only a limited number of exceptions, the automatic stay under the Bankruptcy Code is incredibly broad with the power to stay almost all causes of action filed in both state and federal courts.

Here, Puerto Rico argues that the Recovery Act is outside of the umbrella of the Bankruptcy Code, expressly rejecting preemption arguments, while also seemingly enacting its own automatic stay with similar effects, namely staying all litigation, which presumably includes both state and federal causes of action. However, citing to the Supreme Court in Donovan v. City of Dallas,  the Franklin/Oppenheimer complaint points out that "state courts lack any power under the Constitution to enjoin proceedings in federal court."

While Puerto Rico argues that the federal courts should "'respect and not interfere with a state court's prior in rem jurisdiction," both Puerto Rico and PREPA may still remain subject to ongoing litigation in the federal courts regardless of a filing under the Recovery Act because of the litigation that has already been filed, particularly the constitutional arguments. Puerto Rico's intrastate comity arguments based on in rem jurisdiction may also fail when considering the relationship between state law receivership and the federal provisions of the Bankruptcy Code.

Standing and Ripeness

A major argument in Puerto Rico and PREPA's motions to dismiss the Franklin/Oppenheimer suit is that the plaintiffs lack standing to bring their claims because "neither PREPA - nor any other Puerto Rico public corporation - has sought relief under the Recovery Act" and, therefore, have not sustained the level of injury necessary to challenge the statute. Instead, PREPA characterizes the plaintiffs' claims as "wholly hypothetical, and predicated upon an invocation of the Recovery Act by PREPA that may never occur." The motions to dismiss also argue that the plaintiffs' constitutional challenges are both premature and unripe until PREPA, or any other Puerto Rico public corporation, seeks relief under the Recovery Act.

As if in response to the motions to dismiss, which were filed only a day before BlueMountain's complaint, the BlueMountain complaint argues that the bondholders have already suffered injuries as a result of the laws enactment, most notably by the Act's elimination of the bondholders' right to seek appointment of a receiver upon the occurrence a default under the 1974 Trust Agreement that governs PREPA's bonds. BlueMountain also cites to the already noticeably "depressed" value of the PREPA bonds as another form of actual harm resulting from the Relief Act.


Each of the above arguments, and many that have yet to surface, will undoubtedly cloud Puerto Rico's attempts to restructure its public corporations. A critical issue is timing. As the existing constitutional lawsuits unfold, PREPA faces the expiration of two short-term lines of credit in August, totaling $671 million and including a $550 million line with Scotiabank which must be repaid on Aug. 14. As noted above, disputes over the Anti-Injunction Act could take center stage in the immediate aftermath of a PREPA filing under the new law. That being said, a final resolution of the interplay between the federal Constitution and the new restructuring law will almost certainly involve many levels of appellate review.



Tina’s Wish Junior Committee Summer Event

The financial restructuring community has been a consistent and long-term supporter of The Honorable Tina Brozman Foundation for Ovarian Cancer Research (Tina’s Wish).  The foundation is named in memory of the late Tina Brozman, former Chief Justice of the Southern District Bankruptcy Court and co-head of the financial restructuring practice at Bingham McCutchen.

Reorg Research is proud to be a TEAL sponsor for the upcoming Tina’s Wish Junior Committee Summer Event on Monday, August 11th from 6-8pm at 601 Madison Avenue, 6th floor (between 57th & 58th Streets).  Come by to help support research dedicated to finding an early detection and prevention for ovarian cancer.

The evening will feature a brief and interesting presentation by Memorial Sloan Kettering Researcher, Dr. Dan Haller.

For more information and to pre-register, please visit www.tinabrozmanfoundation.org/summer

Looking forward to seeing you there!



Reorg Research Job Posting - Distressed Debt Legal Analyst

Reorg Research is seeking a Distressed Debt Legal Analyst who is an expert in bankruptcy and/or corporate finance law and has experience in large corporate restructurings. Reorg Research is a growing provider of market-leading analysis and reporting for the distressed debt and restructuring community. Our clients include hedge funds, bankers and legal and financial advisors.

This is an ideal position for a mid-level associate who is seeking to transition to a new career in the distressed debt investing space. The Distressed Debt Legal Analyst will work closely with a small team of in-house experts (from both legal and financial backgrounds) and will be responsible with the rest of the team for producing research, analysis and reporting on distressed debt and bankruptcy law issues.

An ideal candidate will have the following:

  • JD with a strong academic record.
  • An expert understanding of bankruptcy law and 4+ years of bankruptcy law experience involving large chapter 11 cases. We will also consider attorneys with a similar level of experience specializing in corporate or bank finance in the context of large corporate restructurings.
  • Experience negotiating out-of-court restructurings.
  • Experience analyzing financial covenants and intercreditor provisions.
  • A proactive, self-starter work style and able to interact with people from varied professional backgrounds. 
  • A proven ability to multi-task and work both independently and as a team player in a fast-paced environment.

Key responsibilities include:

  • Day-to-day monitoring of distressed situations across the industry.
  • Reporting on case developments on a short timeframe and in accordance with Reorg Research’s style guide.
  • Preparing long-form analysis of legal developments (akin to client alerts at major law firms).
  • Monitoring industry publications.
  • Teleconferences and meetings with lawyers and investment professionals.

We primarily cover large corporate reorganizations and therefore cannot consider candidates whose experience does not include such cases. The candidate will work out of our New York City offices.

For those interested, please send your resume to recruiting [at] reorg-research [dot] com



Reorg Research Coverage of the EFH Bankruptcy

Yesterday was a day I've been waiting on for a long time: EFH (finally!) filed for bankruptcy in Delaware. Our coverage of the litany of filings of dockets has been amazingly comprehensive - we have written 7 stories that the buy side, sell side, advisory and legal communities have been using to stay up to date on the case. Further, our traffic was the highest it's ever been yesterday and hundreds of people in the market are using our docket alerting system to stay up to date with what's going on in the case. RSA gets filed? Our users are the first to see it. Brown Rudnick files an objection five minutes after the filing? We are the first to write it up.

To give you a sense of our coverage, here's a reproduction of our story yesterday on the EFIH DIP that has been proposed on the case. For more information on Reorg Research or to request a trial, you can visit our site here: Reorg Research

Relevant Document:

The debtors have filed a motion seeking approval of a $5.4 billion fully underwritten DIP term facility for EFIH. Proceeds of the DIP will be used to refinance existing EFIH first-lien notes - providing interest savings of $13 million per month. A second-lien DIP of approximately $1.9 billion, expected to be funded by certain PIK holders as disclosed in this morning's 8-K, will be pursued by a separate motion filed shortly. The debtors expect to seek court approval for both DIPs contemporaneously. 

Interest on the first-lien DIP will be L+225, subject to a 1% floor; the facility matures at the earlier of 24 months post-closing or the effective date of any reorganization plan. The term sheet lists a potential junior incremental facility of an amount up to $3 billion, which includes a provision that it shall be converted into equity under a plan of reorganization.

Interestingly, the debtors are pursuing a dual-track approach to the issue of the EFIH first and second lien notes' purported right to a make whole premium. Under this unique and potentially unprecedented approach, EFIH will make settlement overtures to holders of the notes and then pursue litigation against non-consenting holders.

The settlements, which will be further detailed in separate motions to be filed at a later date are:

For the first lien: a tender offer to settling first-lien holders whereby such holders can tender their claims for a 105% of par (inclusive of applicable fees). The payout for this settlement is in "EFIH First Lien DIP Roll-Up Claims" under the new first lien DIP facility. Separately, the debtors will litigate the make whole issue against those holders that do not participate in the settlement tender offer. 

For the second lien: the debtors will separately propose a second-lien refinancing and make-whole settlement funded by the proceeds of the as-yet-unproposed second-lien DIP facility. Pursuant to the second lien settlement, prepetition creditors who agree, other than Fidelity, will get principal and accrued prepetition interest in cash plus 50% of their pro rata make-whole claim. The motion notes that certain second-lien holders have agreed to forgo cash for their make-whole payments, instead taking a share of the second-lien DIP. Fidelity gets the same principal plus accrued treatment, but is also entitled to a one-time payment of $11.25 million plus the "right to receive up to $500 million (plus fees) of its payment under the EFIH Second Lien Settlement in the form of EFIH First Lien DIP Roll-Up Notes."

The motion notes that although certain creditors have agreed to the settlement, the option to participate will be open to all creditors, and the debtors will solicit participation "in accordance with applicable non-bankruptcy securities laws such that solicitation is complete on or around the entry of the final order." Importantly, EFIH will seek to consummate the full first-lien DIP regardless of whether the make-whole settlement is approved. 

The EFIH DIP motion also notes that the EFIH debtors will separately seek authority to assume a restructuring support agreement and that such motion will be filed today or shortly thereafter. According to the motion, if the court "does not approve the roll-ups, creditors may declare a termination event under the Restructuring Support Agreement." 

Despite the roll-up features of the DIP, EFIH argues that it does not pose the risks that typically accompany "roll-up" DIP facilities because "the Prepetition EFIH First Lien Creditors' participation in the syndication of the EFIH First Lien DIP Financing (other than with respect to the EFIH First Lien Settlement) is on the same terms as the other "new money" lenders and does not impose onerous terms on the EFIH Debtors that are typically associated with roll-up DIP facilities."

In addition, a footnote states that "the EFIH Debtors will seek to consummate the full EFIH First Lien DIP Financing regardless of whether the EFIH Makewhole Settlements are approved." However because the EFIH Debtors believe that none of the approximately $1 billion in liquidity necessary over a 26-month period is needed in the first 30 days of the case, the EFIH Debtors are not seeking interim financing or use of EFIH Cash Collateral during the interim period. They are seeking approval of DIP fees pursuant to the Interim Fee Order.

The motion also cites a "First Lien Makewhole Memorandum" that will be filed shortly. Previewing the arguments therein, the EFIH debtors argue that the EFIH first lien indentures do not provide for a makewhole premium "when the outstanding debt is accelerated by the EFIH debtors' chapter 11 filing." Citing to Calpine and S. Side House, the EFIH debtors note that secured creditors may only recover a makewhole premium when the payment is expressly provided for in a contract provision. Next, the debtors argue that the acceleration provision does not contain the phrase "Applicable Premium," which is the defined term that incorporates a makewhole premium in the indenture, nor does it reference the "Optional Redemption" provision that also references "Applicable Premium." As a result, the debtors conclude that the parties to the indenture did not intend to have the makewhole premium due upon a bankruptcy filing. The EFIH debtors request that EFIH first lien notes' claim be allowed in the amount of $3.985 billion, plus accrued and unpaid interest and any other allowable fees and expenses, but "excluding any EFIH First Lien Makewhole Premium." The settlement offer for 105% of par will likely proceed separately from EFIH's litigation of the allowed amount of the first lien claim.

The EFIH DIP motion requires entry of an interim fee order within 10 days of the petition date and entry of a final order within 110 days after the date of the Commitment Letter, which was April 28, 2014.  

The EFIH first-lien arrangers are Deutsche Bank, Citi, Merrill Lynch, Bank of America, Morgan Stanley, Barclays, Royal Bank of Canada, Union Bank, Loop Capital Markets and The Williams Capital Group. 



TMA New York NextGen Hosts "The Future of the Gaming Industry"

I have been affiliated with the Turnaround Management Association's New York Chapter for many years. The NextGen group, comprised of young professionals in the restructuring, distressed, and turnaround industries, is making a fantastic push into putting on certain educational events with the intent to take a topical issue in our space and organizing a group of experienced panelists to shed light on the issue.

On April 10 at 8am, TMA NY NextGen will be hosting an event titled: "The Future of the Gaming Industry: Jackpot or Bust?" Given Caesars is one of the top discussed names in distressed along with a proliferation of industry trends that may weigh on the cash flow and credit stats of a number of names in the space, this event looks to be a phenomenal one.

Panelists include Tom Benninger, of GLC, Scott Butera, CEO of Foxwoods, Dan D'Arrigo, CFO of MGM, and Todd Miranowski of Silver Point. The panel will be moderated by Jeffrey Horwitz of Proskauer.

For more information, or to register, you can visit the TMA page here: TMA Future of Gaming Industry Panel.

Look forward to seeing you there!



hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.