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."
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.
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.
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.